All You Ever Wanted to Know
About U.S. Income Taxation of
Business Enterprises
Jack S. Levin
Donald E. Rocap
Kirkland & Ellis LLP
3/8/05
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
1
Table of contents
I.
Page
no._
What has shaped U.S. business tax system . . . 3
II. 5 sources of U.S. business tax complexity . . . . 5
III. A few examples of undue complexity . . . . . . . 11
IV. Gov’t failures and some possible solutions . . . 42
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
2
I.
What has shaped U.S. business tax system
Competing pressures:
(a) Gov’t seeks to maximize revenue
(b) Taxpayers seek to minimize payments
(c) System should be, and should appear to be, fair
(d) Gov’t often seeks to encourage favored conduct
(risk capital investment, R&D, U.S.-based
production, capital equip purchase)
• and discourage disfavored conduct (high exec
comp, moving hdqs and/or employment
offshore)
(e) Minimize complexity and compliance costs
• Our worst dismal failure
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
3
Conclusion
• Every spec’l provision to encourage/
discourage conduct creates a special rate,
ded’n, or credit, thus creating:
• complexity
• compliance cost
• volumes of new regulations and
definitions
• shelter schemes to obtain the benefit
• appearance of unfairness to those not
obtaining the benefit
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
4
II.
5 sources of U.S. business tax complexity
1. At least 5 different types of entities engage in
business
• C corp
• partnership
• S corp
• LLC
• proprietorship
and they are subject to 3 very different tax
regimes
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
5
2. There are 2 principal sources of financing
for business
• debt and
• equity (common and pfd stock)
which are treated radically differently for
tax purposes
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KIRKLAND & ELLIS LLP
6
3. There are 3 completely different merger/acq’n
systems for taxing a combination of 2 business
enterprises
(a) Tax free
(b) Taxable stock sale
(c) Taxable asset sale
and these 3 systems reach very different results
depending on:
(1) whether target (T) is C corp, S corp, or
p’ship/LLC/proprietorship, and
(2) on form of transaction (asset acq’n or
stock acq’n)
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KIRKLAND & ELLIS LLP
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4. A welter of different tax rates (at least 9)
for different types of income (depending on
whether favored or disfavored)
• and a slew of different treatments for
favored ded’ns
• and a slew of different treatments for
disfavored losses/ded’ns
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
8
Recurring pattern: Gov’t adopts tax incentive
• Then taxpayers squeeze conduct into
favored category to use (or abuse)
incentive
• Then gov’t adopts increasingly complex
and lengthy rules to define favored
category w/ more precision
• Gov’t also tends to split the baby by
retaining tax incentive, but using AMT
system to partially penalize those who
claim incentive
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
9
5. Each C corp must calculate tax under both
of 2 very different complex sets of rules
• Regular income tax rules at rates up to
35%
• Corporate AMT rules at rates up to 20%
and pay larger of the 2 amounts
Existence of 2 radically different tax codes
makes rational tax planning/admin/
compliance geometrically more difficult
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
10
III.
A few examples of undue complexity
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KIRKLAND & ELLIS LLP
11
1. Five different types of business entities
subj’d to three different tax regimes*
(a) C corp
• Subj’d to double taxation:
(1) Corp-level tax (max 35% corp rate) on:
(i)
annual earnings and
(ii) gain on sale of the business assets
(2) S/H-level tax (max 15%) on:
(i)
dividend distrib’n out of earnings and
(ii) gain on sale of stock (including
undistrib’d earnings which make stock
more valuable)
* Spec’l regimes for regulated investment companies (RICs) and real
estate investment trusts (REITs) not herein discussed
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(b) P’ship/LLC/proprietorship
• Flow-thru taxation
• No entity-level tax
• Equity owner subj’d to tax on share of
entity’s income (max 35% indiv’l rate)
• Entity’s accum’d income increases
equity owner’s basis in entity, so
retained earnings not taxed on sale of
entity
• No arbitrary limitations, as there are on
S corp (as discussed below), but publicly
traded p’ship or LLC taxed as C corp
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KIRKLAND & ELLIS LLP
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(c) S corp
• Flow-thru taxation, similar (but not
identical) to p’ship/LLC/
proprietorship
• But if entity is former C corp
• gain on asset sale subj’d to both
(1) entity-level tax and
(2) equity owner-level tax (like C)
• but only on appreciation when
entity switched from C to S
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KIRKLAND & ELLIS LLP
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• Arbitrary and complex limitations on ability
to use S
• No S corp S/H can be p’ship, LLC, corp,
non-resident alien
• Only 1 economic class of S corp stock (so
no pfd stock allowed)
• Only 100 S/Hs (but up to 6 generations of
family members can count as only 1)
• If S corp violates any of above limitations,
automatically turns into C corp (subj to
double tax)
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
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(d) Add’l rule
• Can’t transform C or S corp into
p’ship/LLC w/o triggering tax on all
appreciation
• i.e., treat transformation to p’ship/
LLC as if all C or S corp assets sold
at FV
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KIRKLAND & ELLIS LLP
16
2. Two principal sources of business
capital treated radically differently
(a) Debt financing
• Interest exp is ded’ble, providing
shelter against corp-level tax
• Subj to 6 complex hurdles discussed
in (e) below
• Result: single tax on debt holder
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KIRKLAND & ELLIS LLP
17
(b) Equity financing
• Dividends on common or pfd stock are
not ded’ble at corp-level
• Result: double tax on dividends
• Entity-level tax up to 35%
• S/H-level tax now 15%
• 2d tax (S/H-level) due when S/H
receives dividend or sells stock
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
18
(c) Because C corp equity financing
treated less favorably than debt
financing for tax purposes,
• C corps are motivated to
overleverage, i.e., borrow more and
raise less equity
This is one of the ways some Code
provisions encourage undesirable
conduct
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KIRKLAND & ELLIS LLP
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(d) When debt holder or equity holder is
unrelated foreign person or TEO (e.g., ERISA
plan, university endowment)
(i) No tax on corp’s int payment
• No tax at corp level because int ded’ble,
nor at debt holder level because TEO*
(ii) Single tax on corp’s dividend payment
• Tax at corp level because dividend not
ded’ble, but no tax on equity holder
because TEO**
*
But where debt holder is ERISA plan, there is ultimately tax on ERISA
plan participant (when benefits paid out)
** Where equity holder is ERISA plan, ultimately 2nd tax on plan participant
(when benefits paid out)
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KIRKLAND & ELLIS LLP
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(e) Basic premise for differing treatment of
debt and equity is perfectly rational:
• Because debt is liability, interest yield is
expense
• Because equity is not liability, equity
yield is not expense
But ability to place either debt or equity
label on investment capital offers
enormous tax planning opportunities
So gov’t has responded w/ series of
complex rules to treat debt like equity
where too-closely resembles equity and to
treat equity like debt where too-closely
resembles debt
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KIRKLAND & ELLIS LLP
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In particular, corp must overcome 6
complex interest ded’n hurdles:
(i) Common law/Code §385 subjective
debt-equity rules
(ii) Code §163(e)(5) for high-yield debt
w/ non-cash pay feature
(iii) Code §279 for subord’d acq’n debt
w/ conversion or warrant feature
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(iv) Code §163(j) (test #1) for debt held
by > 50% S/H which is TEO or FP
or p’ship/LLC w/  10% TEO/FP
ownership
(v) Code §163(j) (test #2) for debt
supported by > 50% S/H which is
TEO or FP
(vi) Code §163(l) for debt w/ subst’l int
or prin’l payable in, or by reference
to, equity
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(f) Above debt/equity distinctions are
gen’ly more important for corp than
for p’ship/LLC/proprietorship
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KIRKLAND & ELLIS LLP
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(g) Lease financing for capital equip is a 3d
source of business capital
• Lessor in effect loans money to business,
in exchange for future stream of rental
payments (like principal and interest)
• But lessor takes title to capital equip, so
entitled to accelerated depreciation dedn’s,
which gen’ly exceed lessor’s rental income
in early years, creating front-end tax losses
and sheltering lessor’s other income in
early yrs
• Low (or zero) tax bracket business often
leases (rather than buys) capital equip to
shift accelerated depreciation to high
income lessor
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So gov’t (to protect revenues and accomplish
perceived fairness) promulgates complex rules
to limit such transfer of tax benefits from
lessee to lessor:
• AMT slower depreciation
• Rules to determine “true” owner for tax
purposes
• Passive activity loss limitation
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3. Mgrs and acq’ns
(a) Theoretical underpining for tax-free
org’z’ns and reorgs:
• Exchange of one property for another is
taxable event, triggering appreciation
• But to facilitate business org’z’ns and
reorgs, permit nonrecognition on (e.g.)
combination of 2 enterprises, or division
of 1 enterprise, w/ old owners receiving
stock in new
When taxpayers then seek to extend
tax-free rules to circumstances
resembling sale, gov’t responds w/
increasingly complex and lengthy rules
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KIRKLAND & ELLIS LLP
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(b) §368 reorg’z’n rules
• Available only to C or S corp, not to
p’ship/LLC/proprietorship
• 9 complex and arbitrary pigeon holes,
which turn on formalities such as:
(i) whether transaction is acq’n of T
stock, acq’n of T assets, merger
and
(ii) whether BuyerCo acquires at
parent or subsidiary level:
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KIRKLAND & ELLIS LLP
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• Two-party merger under §368(a)(1)(A)
• Forward subsid’y merger under
§368(a)(2)(D)
• Reverse subsid’y merger under
§368(a)(2)(E)
• Two-party stock-for-stock exchange under
§368(a)(1)(B)
• Three-party subsid’y stock-for-stock
exchange under §368(a)(1)(B)
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KIRKLAND & ELLIS LLP
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• Two-party stock-for-asset exchange under
§368(a)(1)(C)
• Three-party subsid’y stock-for-asset
exchange under §368(a)(1)(C)
• Non-divisive transfer of assets to
commonly controlled corporation under
§368(a)(1)(D)
• Divisive transfer of assets to controlled
corporation under §368(a)(1)(D)
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KIRKLAND & ELLIS LLP
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Each pigeon hole has combination
of silly distinctions not contained
in other pigeon holes:
• Whether substantially all of T’s
assets must be acquired
• Permissibility of non-stock
consideration
• Whether stock consideration
must be voting stock
• Percentage of T’s stock that
must be acquired
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(c) Rules for tax-free contribution of assets
to, and distribution of assets by,
business entities also enormously
complex and differ depending on
nature of assets and type of business
entity
(i) §351 corporate formation rules
• Tax triggered if “control” test
flunked, if corp is an “investment
company,” or if excessive
liabilities are assumed
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KIRKLAND & ELLIS LLP
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(ii) §721 p’ship/LLC formation rules
• Tax triggered if treated as
“disguised sale”
(iii) §355 spin-offs
• Tax triggered if flunk “control,”
“business purpose,” “active
business,” “device,” or other
tests or if distrib’n is treated as
occurring in connection with
certain stock acq’ns
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(d) Taxable acq’n
• Tax result completely different than where
transaction fits a tax-free acq’n pigeon hole
(described above)
• Tax result varies greatly depending on form
of target entity (T)
• and whether BuyerCo acquires T stock or
T assets
(i) Where T is p’ship/LLC/
proprietorship, BuyerCo takes asset
SUB, w/ no double tax on sellers
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
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(ii) Where T is C corp,
(i) BuyerCo takes COB, w/
single tax on sellers, for stock
acq’n and
(ii) SUB, w/ double tax on
sellers, for asset acq’n
(iii) Where T is S corp,
result turns on whether S corp
was C corp at any time during
past 10 yrs
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KIRKLAND & ELLIS LLP
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4. Welter of tax rates and other spec’l treatments
(a) Normal ordinary income top rate is 35%
(for indiv’l or C corp)
(b) Welter of different tax rates for different
types of income (depending on whether
more or less favored than normal ordinary
income):
• 0% for muni bond interest
• 14% for indiv’l’s gain on “small business
stock”
• 15% for indiv’l’s capital gain* and
qualified dividend income
* Capital gain means long-term capital gain throughout this paper
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• 32% (after several yr phase in) for U.S.
net production income
• 36% for indiv’l’s comp income (incl’g
1.45% medicare tax)
• 38% for indiv’l’s self employment
income (incl’g 2.9% medicare tax)
• Add’l 20 points for indiv’l’s disqualified
deferred comp
• Add’l 20 points for indiv’l’s golden
parachute comp
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KIRKLAND & ELLIS LLP
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(c) As one example of complexity caused
by spec’l tax break to encourage
conduct, 10/04 legis’n (new Code
§199) seeks to encourage U.S.-based
production activities by granting
reduced tax rate on U.S. net
production income
• 35% rate phases down to 32% over
several yrs
• Creates tremendous
acctg/admin/audit complexity
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KIRKLAND & ELLIS LLP
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Rate reduction covers business net income from:
(i) sale, lease, other disposition of:
(A) tangible personal prop'y,
computer software,
or sound recording
• mfd, produced, grown, or extracted
by taxpayer w/in U.S.
(B) motion picture film or tape
• produced by taxpayer in U.S., w/ no
"actual sexually explicit conduct"
(C) elec'y, nat'l gas, potable water
• produced by taxpayer in U.S.
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KIRKLAND & ELLIS LLP
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(ii) U.S. construction activities
(iii) engineering or architectural services
in U.S. for U.S. construction project
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Complexities:
• Need to calculate net income from covered
activity, i.e., allocating exps betw covered (U.S.
production) and non-covered activities (U.S.
retail, wholesale, service, and transportation
income and foreign production)
• E.g., exec comp, hdqrs overhead, R&D
• E.g., product which incorporates both U.S.
goods/services
and foreign goods/services
• E.g., allocating net income to non-covered
retailing, wholesaling, transportation, as
opposed to U.S. production
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
41
IV.
Gov’t failures and some possible solutions
(a) Failure of gov’t to make hard decisions
• resulting in multitude of rules, definitions,
exceptions, qualifications, and subcategories, rather than one (or few) rules
• E.g., AMT rules laid on top of regular
tax rules
• To extent AMT rules are sensible,
incorporate them into regular tax
• To extent not sensible, discard!!
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
42
• E.g., C corp interest ded’bility, but
punctuated by 6 complex exceptions
• At least rationalize the 6
• E.g., 9 complex pigeon holes
defining tax-free reorg’z’ns
• At least rationalize the 9
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
43
• E.g., consider whether rate reduction for
U.S. net production income and other
spec’l rates, deductions, etc. worth
signif’t increase in acctg/admin/dispute
costs
• or whether a broader tax base w/
lower rates and no CG/OI distinction
(as in Reagan 1986 legislation) might
be better
• E.g., consider whether, given availability
of LLC form, the separate S corp tax
regime is worth the added complexity
• E.g., consider whether all business
entities should be governed by a unified
single-tax regime
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KIRKLAND & ELLIS LLP
44
(b) Failure of gov’t to stick w/ decisions once
made
• resulting in hundreds of law changes
each yr (many not really nec’y), i.e.,
churning the tax law
• E.g., sunsets for Bush tax reductions
• E.g., on again, off again R&D credits
and bonus depreciation
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KIRKLAND & ELLIS LLP
45
(c) Gov’t efforts to make social policy through
complex tax distinctions
• Golden parachute tax penalties for exec
comp related to change in corp ownership
• incl’g 20 points extra tax on exec and
no corp ded’n
• Limiting to $1m/yr public co’s ded’n for
comp to each of 5 top execs
• w/ no similar limitation on comp to
(e.g.) athlete or actor, nor on
expenditures for (e.g.) advertising or
travel
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KIRKLAND & ELLIS LLP
46
• 10/04 tax penalties for exec receiving
deferred comp not w/in statutory pigeon
holes
• incl’g 20 points extra tax on exec
• Denying rate reduction for U.S. net
production income for “actually
sexually explicit” movie
• making IRS auditors arbiters of
“actually sexually explicit”
• one example of assigning to IRS issues
its auditors are neither trained nor
suited to enforce
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KIRKLAND & ELLIS LLP
47
(d) Complexity, unfairness, and churning
breed contempt for tax law
• E.g., taxpayer disadvantaged by
tax-law change questions why change
nec’y and feels aggrieved
• Hundreds of changes each yr mean
millions of taxpayers feel aggrieved
each yr
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KIRKLAND & ELLIS LLP
48
(e) When a tax principle is submerged in
flood of constantly changing legislative
and regulatory rhetoric,
• artificial shelters grow by seizing on a
few choice words out of the verbal flood
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KIRKLAND & ELLIS LLP
49
(f) While tax complexity inevitable (because
taxes inherently complex),
• much more gov’t effort nec’y to
minimize (rather than geometrically
multiply) complexity
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
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Oral Presentation on
All You Ever Wanted to Know
About U.S. Income Taxation of
Business Enterprises
Jack S. Levin
Donald E. Rocap
Kirkland & Ellis LLP
3/8/05
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
51
Overview
I.
What has shaped U.S. business tax system
II.
5 sources of U.S. business tax complexity
III. A few examples of undue complexity
IV. Gov’t failures and some possible solutions
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
52
I.
What has shaped U.S. business tax system
Competing pressures:
(a) Gov’t seeks to maximize revenue
(b) Taxpayers seek to minimize payments
(c) System should be, and should appear to be, fair
(d) Gov’t often seeks to encourage favored conduct
(risk capital investment, R&D, U.S.-based
production, capital equip purchase)
• and discourage disfavored conduct (high exec
comp, moving hdqs and/or employment
offshore)
(e) Minimize complexity and compliance costs
• Our worst dismal failure
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
53
Conclusion
• Every spec’l provision to encourage/
discourage conduct creates a special rate,
ded’n, or credit, thus creating:
• complexity
• compliance cost
• volumes of new regulations and
definitions
• shelter schemes to obtain the benefit
• appearance of unfairness to those not
obtaining the benefit
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
54
II.
5 sources of U.S. business tax complexity
1. At least 5 different types of entities engage in
business
• C corp
• partnership
• S corp
• LLC
• proprietorship
and they are subject to 3 very different tax
regimes
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
55
2. There are 2 principal sources of financing
for business
• debt and
• equity (common and pfd stock)
which are treated radically differently for
tax purposes
3. There are 3 completely different
merger/acq’n systems for taxing a
combination of 2 business enterprises
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
56
4. A welter of different tax rates (at least 9)
for different types of income (depending on
whether favored or disfavored)
• and a slew of different treatments for
favored ded’ns
• and a slew of different treatments for
disfavored losses/ded’ns
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
57
Recurring pattern: Gov’t adopts tax incentive
• Then taxpayers squeeze conduct into
favored category to use (or abuse)
incentive
• Then gov’t adopts increasingly complex
and lengthy rules to define favored
category w/ more precision
• Gov’t also tends to split the baby by
retaining tax incentive, but using AMT
system to partially penalize those who
claim incentive
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
58
5. Each C corp must calculate tax under both
of 2 very different complex sets of rules
• Regular income tax rules at rates up to
35%
• Corporate AMT rules at rates up to 20%
and pay larger of the 2 amounts
Existence of 2 radically different tax codes
makes rational tax planning/admin/
compliance geometrically more difficult
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
59
III.
A few examples of undue complexity
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
60
1. Five different types of business entities
subj’d to three different tax regimes
(a) C corp
• Subj’d to double taxation:
(1) Corp-level tax (max 35% corp rate) on:
(i) annual earnings and
(ii) gain on sale of the business assets
(2) S/H-level tax (max 15%) on:
(i) dividend distrib’n out of earnings
and
(ii) gain on sale of stock (including
undistrib’d earnings which make
stock more valuable)
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
61
(b) P’ship/LLC/proprietorship
• Flow-thru taxation
• No entity-level tax
• Equity owner subj’d to tax on share of
entity’s income (max 35% indiv’l rate)
• Entity’s accum’d income increases
equity owner’s basis in entity, so
retained earnings not taxed on sale of
entity
• No arbitrary limitations, as there are
on S corp, but publicly traded p’ship or
LLC taxed as C corp
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
62
(c) S corp
• Flow-thru taxation, similar (but not
identical) to p’ship/LLC/
proprietorship
• But if entity is former C corp
• gain on asset sale subj’d to both
(1) entity-level tax and
(2) equity owner-level tax (like C)
• but only on appreciation when
entity switched from C to S
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
63
• Arbitrary and complex limitations on ability
to use S
• No S corp S/H can be p’ship, LLC, corp,
non-resident alien
• Only 1 economic class of S corp stock (so
no pfd stock allowed)
• Only 100 S/Hs (but up to 6 generations of
family members can count as only 1)
• If S corp violates any of above limitations,
automatically turns into C corp (subj to
double tax)
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
64
(d) Add’l rule
• Can’t transform C or S corp into
p’ship/LLC w/o triggering tax on all
appreciation
• i.e., treat transformation to p’ship/
LLC as if all C or S corp assets sold
at FV
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
65
2. Two principal sources of business
capital treated radically differently
(a) Debt financing
• Interest exp is ded’ble, providing
shelter against corp-level tax
• Subj to 6 complex hurdles listed in
appendix
• Result: single tax on debt holder
Tax Reform Panel © 3/05 Jack S. Levin
KIRKLAND & ELLIS LLP
66
(b) Equity financing
• Dividends on common or pfd stock are
not ded’ble at corp-level
• Result: double tax on dividends
• Entity-level tax up to 35%
• S/H-level tax now 15%
• 2d tax (S/H-level) due when S/H
receives dividend or sells stock
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(c) Because C corp equity financing
treated less favorably than debt
financing for tax purposes,
• C corps are motivated to
overleverage, i.e., borrow more and
raise less equity
This is one of the ways some Code
provisions encourage undesirable
conduct
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(d) Basic premise for differing treatment of
debt and equity is perfectly rational:
• Because debt is liability, interest yield is
expense
• Because equity is not liability, equity
yield is not expense
But ability to place either debt or equity
label on investment capital offers
enormous tax planning opportunities
So gov’t has responded w/ series of
complex rules to treat debt like equity
where too-closely resembles equity and to
treat equity like debt where too-closely
resembles debt
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3. Mgrs and acq’ns
(a) Theoretical underpining for tax-free
org’z’ns and reorgs:
• Exchange of one property for another is
taxable event, triggering appreciation
• But to facilitate business org’z’ns and
reorgs, permit nonrecognition on (e.g.)
combination of 2 enterprises, or division
of 1 enterprise, w/ old owners receiving
stock in new
When taxpayers then seek to extend
tax-free rules to circumstances
resembling sale, gov’t responds w/
increasingly complex and lengthy rules
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(b) §368 reorg’z’n rules
• Available only to C or S corp, not to
p’ship/LLC/proprietorship
• 9 complex and arbitrary pigeon holes
listed in appendix, which turn on
formalities such as (i) whether the
transaction is acq’n of target entity (T)
stock, acq’n of T assets, merger and
(ii) whether BuyerCo acquires at
parent or subsidiary level
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Each pigeon hole has combination
of silly distinctions not contained
in other pigeon holes:
• Whether substantially all of T’s
assets must be acquired
• Permissibility of non-stock
consideration
• Whether stock consideration
must be voting stock
• Percentage of T’s stock that
must be acquired
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(c) Rules for tax-free contribution of
assets to, and distribution of assets by,
business entities also enormously
complex and differ depending on the
nature of assets and type of business
entity
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(d) Taxable acq’n
• Tax result completely different than
where transaction fits a tax-free acq’n
pigeon hole
• As described in appendix, tax result
varies greatly depending on whether T
is C corp, S corp or p’ship/LLC
• and whether BuyerCo acquires T
stock or T assets
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4. Welter of tax rates and other spec’l treatments
(a) Normal ordinary income top rate is 35%
(for indiv’l or C corp)
(b) Welter of different tax rates for different
types of income (depending on whether
more or less favored than normal ordinary
income):
• 0% for muni bond interest
• 14% for indiv’l’s gain on “small business
stock”
• 15% for indiv’l’s capital gain and
qualified dividend income
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• 32% (after several yr phase in) for U.S.
net production income
• 36% for indiv’l’s comp income (incl’g
1.45% medicare tax)
• 38% for indiv’l’s self employment
income (incl’g 2.9% medicare tax)
• Add’l 20 points for indiv’l’s disqualified
deferred comp
• Add’l 20 points for indiv’l’s golden
parachute comp
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One example of tax break to encourage conduct is
new reduced tax rate (phasing down to 32%) on
U.S. net production income
Rate reduction covers net income from activities
including sale of:
(i) tangible personal prop'y, computer
software, or sound recording
• mfd, produced, grown, or extracted by
taxpayer w/in U.S.
(ii) motion picture film or tape
• produced by taxpayer in U.S., w/ no
"actual sexually explicit conduct"
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Creates tremendous acctg/admin/audit
complexity:
• Need to calculate net income from covered
activity, i.e., allocating receipts and exps
betw covered (U.S. production) and noncovered activities (U.S. retail, wholesale,
service, and transportation income and
foreign production)
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IV.
Gov’t failures and some possible solutions
(a) Failure of gov’t to make hard decisions
• resulting in multitude of rules, definitions,
exceptions, qualifications, and subcategories, rather than one (or few) rules
• AMT rules laid on top of regular tax
rules
• To extent AMT rules are sensible,
incorporate them into regular tax
• To extent not sensible, discard!!
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• C corp interest ded’bility, but
punctuated by 6 complex exceptions
• At least rationalize the 6 exceptions
• 9 complex pigeon holes defining taxfree reorg’z’ns
• At least rationalize the 9 pigeon
holes
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• Consider whether rate reduction for U.S.
net production income and other spec’l
rates, deductions, etc. worth signif’t
increase in acctg/admin/dispute costs
• or whether a broader tax base w/ lower
rates and no CG/OI distinction (as in
Reagan 1986 legislation) might be
better
• Consider whether, given availability of
LLC form, the separate S corp tax regime
is worth the added complexity
• Consider whether all business entities
should be governed by a unified single-tax
regime
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(b) Failure of gov’t to stick w/ decisions once
made
• resulting in hundreds of law changes
each yr (many not really nec’y), i.e.,
churning the tax law
• Sunsets for Bush tax reductions
• On again, off again R&D credits and
bonus depreciation
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(c) Gov’t efforts to make social policy through
complex tax distinctions
• Golden parachute tax penalties for exec
comp related to change in corp ownership
• Limiting to $1m/yr public co’s ded’n for
comp to each of 5 top execs
• w/ no similar limitation on comp to
(e.g.) athlete or actor, nor on
expenditures for (e.g.) advertising or
travel
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• 10/04 tax penalties for exec receiving
deferred comp not w/in statutory pigeon
holes
• Denying rate reduction for U.S. net
production income for “sexually
explicit” movie
• making IRS auditors arbiters of
sexually explicit
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(d) Complexity, unfairness, and churning
breed contempt for tax law
• Taxpayer disadvantaged by tax-law
change questions why change nec’y and
feels aggrieved
• Hundreds of changes each yr mean
millions of taxpayers feel aggrieved
each yr
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(e) When a tax principle is submerged in
flood of constantly changing legislative
and regulatory rhetoric,
• artificial shelters grow by seizing on a
few choice words out of the verbal flood
(f) While tax complexity inevitable (because
taxes inherently complex),
• much more gov’t effort nec’y to
minimize (rather than geometrically
multiply) complexity
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Appendix
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1. Additional notes on debt-equity distinction
(a) When debt holder or equity holder is unrelated
foreign person or TEO (e.g., ERISA plan,
university endowment)
(i) No tax on corp’s int payment
• No tax at corp level because int ded’ble,
nor at debt holder level because TEO*
(ii) Single tax on corp’s dividend payment
• Tax at corp level because dividend not
ded’ble, but no tax on equity holder
because TEO**
*
But where debt holder is ERISA plan, there is ultimately tax on ERISA
plan participant (when benefits paid out)
** Where equity holder is ERISA plan, ultimately 2nd tax on plan participant
(when benefits paid out)
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(b) 6 complex interest ded’n hurdles for
corps:
(i) Common law/Code §385 subjective
debt-equity rules
(ii) Code §163(e)(5) for high-yield debt
w/ non-cash pay feature
(iii) Code §279 for subord’d acq’n debt
w/ conversion or warrant feature
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(iv) Code §163(j) (test #1) for debt held
by > 50% S/H which is TEO or FP
or p’ship/LLC w/  10% TEO/FP
ownership
(v) Code §163(j) (test #2) for debt
supported by > 50% S/H which is
TEO or FP
(vi) Code §163(l) for debt w/ subst’l int
or prin’l payable in, or by reference
to, equity
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(c) Debt/equity distinctions are gen’ly
more important for corp than for
p’ship/LLC/proprietorship
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2. Lease financing for capital equip is a 3d source of
business capital
• Lessor in effect loans money to business,
in exchange for future stream of rental
payments (like principal and interest)
• But lessor takes title to capital equip, so
entitled to accelerated depreciation dedn’s,
which gen’ly exceed lessor’s rental income in
early years, creating front-end tax losses and
sheltering lessor’s other income in early yrs
• Low (or zero) tax bracket business often leases
(rather than buys) capital equip to shift
accelerated depreciation to high income lessor
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So gov’t (to protect revenues and accomplish
perceived fairness) promulgates complex rules
to limit such transfer of tax benefits from
lessee to lessor:
• AMT slower depreciation
• Rules to determine “true” owner for tax
purposes
• Passive activity loss limitation
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3. Reorganization pigeon holes
• Two-party merger under §368(a)(1)(A)
• Forward subsid’y merger under §368(a)(2)(D)
• Reverse subsid’y merger under §368(a)(2)(E)
• Two-party stock-for-stock exchange under
§368(a)(1)(B)
• Three-party subsid’y stock-for-stock exchange under
§368(a)(1)(B)
• Two-party stock-for-asset exchange under
§368(a)(1)(C)
• Three-party subsid’y stock-for-asset exchange under
§368(a)(1)(C)
• Non-divisive transfer of assets to commonly controlled
corporation under §368(a)(1)(D)
• Divisive transfer of assets to controlled corporation
under §368(a)(1)(D)
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4. Tax-free contributions and distributions
(a) §351 corporate formation rules
• Tax triggered if “control” test flunked, if
corp is an “investment company,” or if
excessive liabilities are assumed
(b) §721 p’ship/LLC formation rules
• Tax triggered if treated as “disguised
sale”
(c) §355 spin-offs
• Tax triggered if flunk “control,” “business
purpose,” “active business,” “device,” or
other tests or if distrib’n is treated as
occurring in connection with certain stock
acq’ns
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5. Taxable acquisitions
(a) Where T is p’ship/LLC/ proprietorship,
BuyerCo takes asset SUB, w/ no double tax
on sellers
(b) Where T is C corp,
(i) BuyerCo takes COB, w/ single tax on
sellers, for stock acq’n and
(ii) SUB, w/ double tax on sellers, for
asset acq’n
(c) Where T is S corp,
result turns on whether S corp was
C corp at any time during past 10 yrs
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