# Presentation: 023888

## All You Ever Wanted to Know About U.S. Income Taxation of Business Enterprises

**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**

## Table of contents		Page	   no._

**What has shaped U.S. business tax system****	****. . .   3**
**5 sources of U.S. business tax complexity  . . . .   5**
**A few examples of undue complexity****	**** . . . . . . . 11**
**Gov’t failures and some possible solutions****	**** . . . 42**

## 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**

## 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

**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**

## 5 sources of U.S. business tax complexity

**At least 5 different types of entities engage in business **
**	****and they are subject to 3 very different tax regimes**

## There are 2 principal sources of financing for business
debt and
equity (common and pfd stock)
	which are treated radically differently for tax purposes

**debt and**
**equity (common and pfd stock)**
**	****which are treated radically differently for tax purposes**

## 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)

**(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)**

## 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

**and a slew of different treatments for **_**favored**_** ded’ns**
**and a slew of different treatments for **_**disfavored**_** losses/ded’ns**

## 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

**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**

## 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 

**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**** **

## A few examples of undue complexity

## 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)

**(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)**

## (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

**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**

## (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

**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**

## 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)

**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)**

## (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

**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**

## 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

**(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**

## (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

**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**

## (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

**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**

## (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**

**(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********

## (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 

**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 **

## 	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

**(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**

## (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

**(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**

## (f)	Above debt/equity distinctions are gen’ly more important for corp than for p’ship/LLC/proprietorship

## (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

**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**

## 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

**AMT slower depreciation**
**Rules to determine “true” owner for tax purposes**
**Passive activity loss limitation**

## 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

**(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**

## (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:

**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:**

## 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)

**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)

**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)**

## 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

**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**

## (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

**(i)****	****§351 corporate formation rules**
**Tax triggered if “control” test flunked, if corp is an “investment company,” or if excessive liabilities are assumed**

## (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

**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**

## (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 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**

## (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

**(iii)****	****Where T is S corp, ****result turns on whether S corp was C corp at any time during past 10 yrs**

## 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

**(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**

## 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

**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**

## (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**

## 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.

**(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.**

## (ii)	U.S. construction activities
(iii)	engineering or architectural services in U.S. for U.S. construction project

**(iii)****	****engineering or architectural services in U.S. for U.S. construction project**

## 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

**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**

## 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 sub-categories, 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!!**

## 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

**At least rationalize the 6 **
**E.g., 9 complex pigeon holes defining tax-free reorg’z’ns**
**At least rationalize the 9**

## 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

**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**

## (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

**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**

## (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

**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**

## 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

**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**

## (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

**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**

## (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  

**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 

**much more gov’t effort nec’y to minimize (rather than geometrically multiply) complexity **

## Oral Presentation on

**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**

## Overview	

**What has shaped U.S. business tax system**
**5 sources of U.S. business tax complexity**
**A few examples of undue complexity**
**Gov’t failures and some possible solutions**

## 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**

## 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

**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**

## 5 sources of U.S. business tax complexity

**At least 5 different types of entities engage in business **
**	****and they are subject to 3 very different tax regimes**

## There are 2 principal sources of financing for business
debt and
equity (common and pfd stock)
	which are treated radically differently for tax purposes
There are 3 completely different merger/acq’n systems for taxing a combination of 2 business enterprises 

**debt and**
**equity (common and pfd stock)**
**	****which are treated radically differently for tax purposes**
**There are 3 completely different merger/acq’n systems for taxing a combination of 2 business enterprises **

## 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

**and a slew of different treatments for **_**favored**_** ded’ns**
**and a slew of different treatments for **_**disfavored**_** losses/ded’ns**

## 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

**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**

## 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 

**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**** **

## A few examples of undue complexity

## 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)

**(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)**

## (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

**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**

## (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

**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**

## 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)

**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)**

## (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

**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**

## 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

**(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**

## (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

**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**

## (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

**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**

## (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 

**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 **

## 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

**(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**

## (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

**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**

## 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

**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**

## (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

## (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

**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**

## 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

**(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**

## 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

**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**

## 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"**

## 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 non-covered activities (U.S. retail, wholesale, service, and transportation income and foreign production)

**Need to calculate **_**net**_** income from covered activity, i.e., allocating receipts and exps betw covered (U.S. production) and non-covered activities (U.S. retail, wholesale, service, and transportation income and foreign production)**

## 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 sub-categories, 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!!**

## C corp interest ded’bility, but punctuated by 6 complex exceptions
At least rationalize the 6 exceptions
9 complex pigeon holes defining tax-free reorg’z’ns
At least rationalize the 9 pigeon holes

**At least rationalize the 6 exceptions**
**9 complex pigeon holes defining tax-free reorg’z’ns**
**At least rationalize the 9 pigeon holes**

## 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

**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**

## (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

**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**

## (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

**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**

## 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

**Denying rate reduction for U.S. net production income for “sexually explicit” movie**
**making IRS auditors arbiters of sexually explicit**

## (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

**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**

## (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   

**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   **

## Appendix

## 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**

**(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)**

## (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

**(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**

## (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

**(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**

## (c)	Debt/equity distinctions are gen’ly more important for corp than for p’ship/LLC/proprietorship

## 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

**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**

## 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

**AMT slower depreciation**
**Rules to determine “true” owner for tax purposes**
**Passive activity loss limitation**

## 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)

**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)**

## 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

**(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**

## 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

**(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**