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March 26, 2012
Will Rate Changes Transform C Corps Into Tax Shelters?

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By Martin A. Sullivan --

In the days before the Tax Reform Act of 1986, when the top individual rate was above the corporate rate, wealthy owners of closely held businesses kept as much money as possible in subchapter C corporations. That was basic tax planning, but it was a hassle.

Practitioners made small fortunes helping clients avoid anti-deferral rules and devising low-tax means of distributing accumulated profits. With corporate rates above individual rates after 1986, the C corp's role as a tax shelter was greatly diminished. If, as President Obama proposes, the corporate rate goes down to 28 percent and the individual rate goes up to 39.6 percent, we could return to a world where that costly tax planning technique once again becomes commonplace. That is what most witnesses told the House Ways and Means Committee at the March 7 hearing on closely held businesses. (For prior coverage, see Tax Notes, Mar. 12, 2012, p. 1375.)

The Obama rate reversal would be "very harmful" and "a huge mistake," according to Dewey Martin, testifying on behalf of the National Federation of Independent Business (Doc 2012-4835, 2012 TNT 46-40 ). Currently, the top individual and corporate statutory rates are both 35 percent. To prevent the tax system's relapse to its pre-1986 state, witnesses urged the committee in the strongest terms to keep the individual and corporate rates equal.

"There should be tax rate parity," Stefan Tucker told the committee (Doc 2012-4837, 2012 TNT 46-45). The corporate and the top individual rates "should be exactly the same," he reiterated. Judging by their comments and questions, most Republican members were inclined to agree.

With concern growing about the competitiveness of U.S. corporations, there is widespread bipartisan agreement about the need for cutting the corporate tax rate. (For a discussion of the practical benefits of a corporate rate reduction, see Tom Neubig, "Where's the Applause? Why Most Corporations Prefer a Lower Rate," Tax Notes, Apr. 24, 2006, p. 483, Doc 2006-7026, or 2006 TNT 79-41.)

There is a strong partisan divide about the future of individual rates. Emphasizing the need for deficit reduction and the desire for the wealthy to pay a larger share of total revenue, Democrats are pushing harder than ever for increases to the top individual rates. (To promote fairness, it would be better for them to advocate for a broader base and the elimination of the preferential rate on capital gains -- but that's another story.)

Meanwhile, Republicans want rates to stay where they are or decline. The tax reform discussion draft from Ways and Means Chair Dave Camp, R-Mich., proposes a reduction of the top individual rate, along with the top corporate rate, to 25 percent. And cuts in the top individual and corporate rates to 25 percent are the flagship tax provisions of the new budget outline from House Budget Committee Chair Paul Ryan, R-Wis. (For related coverage, see p. 1595.)

Is it important, as Camp said in his opening statement, to "closely align individual and corporate rates to eliminate abuse and economic distortions relating to business structures"? This article argues that the answer is no.

How to Pay for a Corporate Rate Cut

A lower corporate rate is chicken soup for the code. It helps cure many ills with few adverse side effects. It would increase capital formation and add to growth. It would increase compliance. It would reduce the tax bias for issuing debt over equity, for retained earnings over distributions, and for booking profits offshore instead of in the United States.

The hard part is paying for it. Value added taxation? That major revenue source, adopted by every other major economy, should be getting more attention, but for now it has no traction on Capitol Hill or in the White House. Cutting business tax expenditures? That approach has limited possibilities and, as emphasized at the Ways and Means hearing, it would raise taxes on passthrough businesses that would not benefit from a lower corporate rate. Limiting interest deductions is another excellent idea that has received only limited attention despite its inclusion in the Bipartisan Tax Fairness and Simplification Act of 2011 proposed by Senate Finance Committee member Ron Wyden, D-Ore., and Sen. Daniel Coats, R-Ind., and, more recently, appearing on the list of possible revenue raisers included in the president's corporate reform framework (Doc 2012-3711, 2012 TNT 36-18). Given the lack of enthusiasm for any of these options, raising the top individual rate on ordinary income cannot be taken off the table.

The first thing to notice about this approach is that from an international perspective, there is nothing unusual about a top individual rate exceeding the corporate rate. Table 1 shows that among the top personal and corporate rates in OECD countries, the average top personal rate of 41.3 percent is a whopping 15.8 percentage points higher than the average corporate rate of 25.5 percent. In 28 out of 33 countries, the individual rate is higher than the corporate rate. (The tax rates in this table and Table 2 include subnational taxes.) So, viewed in this light, Obama's proposal to raise individual rates above the corporate rate is entirely consistent with international norms.

Tax on Distributions Also Important

But the potential for using C corporations as a tax shelter does not just depend on the values of the corporate and individual rates. The taxation of distributions from C corporations plays a critical role. More precisely, the choice between the passthrough and the corporate form depends on the relative value of the individual rate (on passthrough income) to the sum of the corporate rate plus the effective tax rate on distributions. professor Daniel Halperin of Harvard Law School emphasized that in a 2010 article: "If the combined tax at the corporate level and on corporate distributions is sufficiently higher than the U.S. individual rate, closely held businesses might continue to prefer passthrough entities." (See "Mitigating the Potential Inequity of Reducing Corporate Rates," Tax Notes, Feb. 1, 2010, p. 641, Doc 2010-261, or 2010 TNT 34-10.)

The effective tax rate on most dividends is 15 percent. The effective tax rate on profits realized through capital gains is less than the 15 percent statutory rate because many gains are deferred. And with the step-up in basis at death, capital gains can have an effective income tax rate of zero.

Table 2 compares passthrough rates with combined individual and corporate tax rates in OECD countries in 2011. Including both state and federal taxes, Table 2 shows that the combined individual and corporate tax rate on corporate income is 54.1 percent in the United States. That is more than 10 percentage points higher than the estimated corporate rate. The table suggests that if all corporate earnings are distributed as they are earned, the federal statutory rate could be reduced to 25 percent, and the rate differential that mattered would still tilt in favor of keeping income outside C corporations.

          Table 1. Comparison of the Top Individual Rate and
          Statutory Corporate Rate in OECD Countries in 2011

                               Country      Top            Difference
                               Corporate    Individual     (percentage
                               Rate         Tax Rate       points)

 Average excluding U.S.           25.5         41.3           15.8

 Australia                        30           46.5           16.5
 Austria                          25           50             25
 Belgium                          34           53.7           19.7
 Canada                           27.6         46.4           18.8
 Chile                            20           40             20
 Czech Republic                   19           15             -4
 Denmark                          25           52.2           27.2
 Estonia                          21           21              0
 Finland                          26           49.2           23.2
 France                           34.4         46.7           12.3
 Germany                          30.2         47.5           17.3
 Greece                           20           45             25
 Hungary                          19           16             -3
 Iceland                          20           46.2           26.2
 Ireland                          12.5         48             35.5
 Israel                           24           45             21
 Italy                            27.5         45.6           18.1
 Japan                            39.5         50             10.5
 Korea                            24.2         38.5           14.3
 Luxembourg                       28.8         41.3           12.5
 Mexico                           30           30              0
 Netherlands                      25           52             27
 New Zealand                      28           33              5
 Norway                           28           40             12
 Poland                           19           32             13
 Portugal                         26.5         50             23.5
 Slovak Republic                  19           19              0
 Slovenia                         20           41             21
 Spain                            30           45             15
 Sweden                           26.3         56.6           30.3
 Switzerland                      21.2         41.7           20.5
 Turkey                           20           35.7           15.7
 United Kingdom                   26           50             24
 United States                    39.2         41.9           2.7

 Source: OECD, "OECD Tax Database." Data include state, local, and
 provincial taxes.

Table 2 measures 2011 taxes. In 2013 the top individual rate on ordinary income might increase. And in 2013 the rate on distributions will increase as the 3.8 percent Medicare tax on investment income kicks in. Also, there is a real possibility of a dividend tax increase. (For more details and calculations of the integrated rate of corporate equity in 2012, see Robert Carroll and Gerald Prante, "Corporate Dividend and Capital Gains Taxation: A Comparison of the United States to Other Developed Nations," Ernst & Young LLP (Feb. 2012) Doc 2012-2633 or 2012 TNT 28-51.)

               Table 2. Comparison of the Top Individual Rate and
          Combined Corporate and Personal Tax Rate on Distributions in
                             OECD Countries in 2011

                          Net            Corporate
                          Personal       And Personal   Top
                          Tax on         Tax on         Individual  Difference
 Country                  Distribution   Distribution   Tax Rate    of Last Two

 Average excluding U.S.       20.7           40.8          41.3         0.5

 Australia                    23.6           46.5          46.5         0
 Austria                      25             43.8          50           6.3
 Belgium                      15             43.9          53.7         9.8
 Canada                       28.2           48            46.4        -1.6
 Chile                        27.7           42.2          40          -2.2
 Czech Republic               15             31.2          15         -16.2
 Denmark                      42             56.5          52.2        -4.3
 Estonia                       0             21            21           0
 Finland                      19.6           40.5          49.2         8.7
 France                       35.6           57.8          46.7       -11
 Germany                      26.4           48.6          47.5        -1.1
 Greece                       21             32.5          45          12.5
 Hungary                      16             32            16         -16
 Iceland                      20             36            46.2        10.2
 Ireland                      41             48.4          48          -0.4
 Israel                       25             43            45           2
 Italy                        12.5           36.6          45.6         9
 Japan                        10             45.6          50           4.4
 Korea                        31.1           47.8          38.5        -9.3
 Luxembourg                   19.5           42.5          41.3        -1.2
 Mexico                        0             30            30           0
 Netherlands                  25             43.8          52           8.3
 New Zealand                   6.9           33            33           0
 Norway                       28             48.2          40          -8.2
 Poland                       19             34.4          32          -2.4
 Portugal                     21.5           42.3          50           7.7
 Slovak Republic               0             19            19           0
 Slovenia                     20             36            41           5
 Spain                        19             43.3          45           1.7
 Sweden                       30             48.4          56.6         8.1
 Switzerland                  20             36.9          41.7         4.7
 Turkey                       17.5           34            35.7         1.7
 United Kingdom               36.1           52.7          50          -2.7
 United States                21.2           52.1          41.9       -10.2

 Source: OECD, "OECD Tax Database."

The table is made possible by a huge data collection effort by the OECD. But it provides a simplified picture. It overstates the burden on shareholder income because it assumes all distributions are fully taxed (and in particular, there is no benefit of deferral of gains). The combined tax rates shown are probably best interpreted as the maximum total tax rates that apply to corporate income.

The effective tax rate of distributions will vary widely according to circumstances, particularly how long earnings are kept inside the corporation before they are distributed, so it is hard to calculate and hard to summarize numerically. Perhaps that is why simply comparing individual and corporate rates has developed into a shorthand method of evaluating corporate versus passthrough options. It is true that as individual rates rise relative to corporate rates, the playing field tilts in favor of the corporate form. But there is nothing magical about keeping rates equal. There is nothing neutral about such a system, as Camp implied in his opening statement at the hearing. Since individual taxation of corporate distributions is usually positive, the corporate rate can be lower than the individual rate and still not trigger a migration from passthrough to corporate form.

In the United States, the traditional tools for minimizing low-tax buildup inside corporations are the accumulated earnings tax and personal holding company tax. (See Jeffrey Kwall, "Subchapter G of the Internal Revenue Code: Crusade Without a Cause?" Virginia Tax Review, 1985.) Basically, these two provisions raise the tax rate on undistributed corporate income when tax avoidance is suspected to be the reason for keeping profits inside the corporate shell. The rules are arcane and maddeningly imprecise. If the top individual rate rises significantly above the corporate rate and nothing else is done, the rules should be overhauled and simplified. But given other options, relying on anti-deferral rules is not necessary.

Tax Increase on Distributions?

Another approach to preventing C corporations from becoming tax shelters is to raise taxes on distributions. That entails a variety of possibilities. The first and most obvious is raising the tax on capital gains and qualified dividends. For the top brackets, the rates will revert to their pre-2001 levels of 20 and 39.8 percent, respectively, at the beginning of 2013. The Obama administration endorsed this approach in its latest budget.

In a provocative 2010 paper, Rosanne Altshuler, Benjamin Harris, and Eric Toder argue in favor of lowering the corporate tax rate and considering the possibility of paying for the lower rate by taxing capital gains and dividends as ordinary income. They estimate the corporate rate could be reduced to 26 percent under their approach, which they argue that this would both promote economic growth and increase the progressivity of the tax system. (For the paper, see Doc 2010-11525 or 2010 TNT 100-29.)

In 2011 congressional testimony, professor Michael Graetz of Columbia Law School explained why he changed his view and now favors a low corporate rate and higher tax on distributions. Because of Graetz's prominent role at Treasury when it was developing what turned out to be the basic framework for current law, his revised views on the subject are worth quoting at length:

    In the early 1990s, when Glenn Hubbard and I were both serving there, the Treasury released a study of corporate integration ideas designed to reduce some of the distortions of the classical corporate tax system that I mentioned earlier. . . . That report recommended exemptions from individual taxation of dividends paid out of corporate profits that had already been subjected to U.S. corporate taxes. President George W. Bush urged that Congress enact a similar proposal in 2003, and his recommendation led to the 15 percent rate that now applies to most corporate dividends.

    I will not insist here that we were right when the Treasury report was issued, but even if we were right then, that policy is now wrong. It is far easier and, I believe now better tax policy, to collect income taxes from individual citizens and resident shareholders than from multinational business enterprises. We would be far better off, for example, if a 15 percent rate applied at the business level with a 35 percent tax on dividend recipients, rather than vice versa, which is what we now have. Even a 25/25 rate split would be a substantial improvement over current law. [ Doc 2011-4868 , 2011 TNT 46-37.]

But rates on corporate distributions are not everything -- particularly on dividends -- because in the real world, closely held businesses almost always pay out current earnings to owners as salaries. Simply raising their rates will not counterbalance a positive individual-corporate rate differential if there are loopholes that allow owners to escape the tax.

Halperin addresses this issue at length. To prevent avoidance of individual taxation on corporate income, he recommends reducing both the step-up in basis at death and any deductions for charitable contributions of stock by the amount of any undistributed corporate earnings. He also recommends that passive income inside a corporation be taxed at the individual rate to prevent investment from being shifted into closely held C corporations. And to prevent owners from disguising profit as salary, he would not allow C corporation profits to provide a return on investment that exceeded a rate of return based on market rates.

Finally, when considering the subject of discouraging C corporations from being used as tax shelters, it is important to keep in mind the complexity induced by the graduated corporate rate structure and the simplification that would result from eliminating graduated corporate tax rates. A flat corporate rate structure would put a stop to many small businesses choosing subchapter C status under current law. (See Kwall, "The Repeal of Graduated Corporate Tax Rates," Tax Notes, June 27, 2011, p. 1395, Doc 2011-12306, or 2011 TNT 126-7; and Martin Sullivan, "The Small Business Love-Hate Relationship With Corporate Tax," Tax Notes, Sept. 26, 2011, p. 1321, Doc 2011-20120, or 2011 TNT 186-1.) And if individual rates go up, eliminating graduated corporate rates will be even more important for reducing complexity. The estimated revenue gain from flattening corporate rates would be about $2.5 billion annually.

Just Say No

There is one astonishingly simple solution that has not gotten nearly the attention it deserves: Do not allow closely held businesses to become C corporations. The proposal would not only prevent new complexity from arising from any rate reversal, it would be a significant simplification under current law by eliminating the ability of businesses to opt into this complex form. The limitation in tax status would not in any way deny access to the limited liability protection of incorporation.

This idea has already been floated in a different context. It was one component of two separate but similar proposals to simplify small business taxation by professor Jeffrey Kwall of Loyola University Chicago Law School and professor George Yin of the University of Virginia Law School (Kwall, "Taxing Private Enterprise in the New Millennium," Tax Lawyer, vol. 51, no. 2, 1997; and Yin, "The Future Taxation of Private Business Firms," Florida Tax Review, vol. 4, 1999).

In 2009 Yin wrote: "A straightforward way to avoid the tax shelter problem is to restrict the corporate tax to public corporations and their subsidiaries." (See "Corporate Tax Reform, Finally, After 100 Years," Doc 2009-18078, 2009 TNT 172-38.) By making subchapter C off-limits to closely held businesses, we could jettison the code sections pertaining to personal holding companies and the accumulated earnings tax. More significantly, as Yin has pointed out, almost all the distribution rules, which are focused on preventing ordinary dividends from being taxed as capital gains, could be eliminated because they are targeted at transactions carried out by closely held corporations.

Kwall was a witness at the Ways and Means hearing. When Camp asked about the potentially problematic nature of the administration proposals that included individual rates exceeding the corporate rate, Kwall replied:

    Clearly, under existing law, I would agree that it is very important that there be a balance between the maximum individual rate and the maximum corporate tax rate, or else as we have seen in the past when corporate rates were much lower than individual rates, there is pressure to use corporations as a tax shelter. However, under my proposal I would not allow closely held businesses access to the C corporation regime. I don't think they belong in that regime. And if they are outside of that regime, there are two independent regimes, and it would not be a problem.

Too bad more people weren't listening.

Sure, a lower corporate rate can raise administrative and compliance problems. But those can be managed. Moreover, there are larger issues that tax reform must address. Cutting the corporate rate is the best way to reduce the burden imposed by our most economically harmful tax. It is the best way of using the tax code to increase productivity and international competitiveness. Parity or near parity of individual and corporate tax is a misplaced priority. It would needlessly put policymakers in a straitjacket and make the already challenging task of corporate tax reform exponentially more diffic

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