PRESENT LAW AND BACKGROUND RELATING 

TO SELECTED BUSINESS TAX ISSUES 

Scheduled for a Public Hearing 

Before the 

SENATE COMMITTEE ON FINANCE 

on September 20, 2006 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

 

September 19, 2006 

JCX-41-06
i 

CONTENTS 

Page

INTRODUCTION .......................................................................................................................... 1 

I. SUMMARY ....................................................................................................................... 2 

II. OVERVIEW OF BUSINESS TAXATION ....................................................................... 3 

A. In General..................................................................................................................... 3 

B. Federal Income Tax Rates............................................................................................ 4 

C. Choice of Entity ........................................................................................................... 6

III. DATA ON THE NUMBER AND SIZE OF BUSINESS ENTITIES IN THE 

UNITED STATES............................................................................................................ 16 

IV. CORPORATE INTEGRATION ...................................................................................... 26 

A. Background and Issues............................................................................................... 26 

B. Integration Approaches .............................................................................................. 29 

V. MERGERS, ACQUISITIONS, AND RELATED TAX-FREE TRANSACTIONS ....... 31 

A. Taxable Corporate Transactions................................................................................. 31 

B. Tax-Free Corporate Transactions............................................................................... 32 

C. Issues Relating to Mergers and Acquisitions ............................................................. 40 

VI. ISSUES RELATED TO CAPITAL COST RECOVERY................................................ 43 

A. In general.................................................................................................................... 43 

B. Concept of Cost Recovery ......................................................................................... 44 

C. Examples: Methods of Cost Recovery...................................................................... 47 

D. Incentives for Capital Investment .............................................................................. 51 

E. Present-Law Cost Recovery Tax Rules...................................................................... 53 

VII. INTERNATIONAL TAX ISSUES .................................................................................. 55 

A. In General................................................................................................................... 55 

B. The U.S. International Tax System ............................................................................ 57 

1. Tax treatment of foreign activities of U.S. persons ............................................. 57 

2. Tax treatment of U.S. activities of foreign persons ............................................. 62 

3. Transfer pricing.................................................................................................... 63 

4. Treaties................................................................................................................. 64 
1 

INTRODUCTION 

The Senate Committee on Finance has scheduled a public hearing for September 20, 

2006, on objectives, deficiencies, and options for reforming the U.S. business tax system. This 

document,1

 prepared by the staff of the Joint Committee on Taxation, provides an overview of 

present law related to a variety of hearing topics, including choice of business entity, corporate 

integration, mergers and reorganizations, cost recovery, and international tax systems. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Present Law and 

Background Relating to Selected Business Tax Issues (JCX-41-06), September 19, 2006. 
2 

I. SUMMARY 

Businesses can operate through a variety of legal forms, including C corporations, 

general partnerships, limited partnerships, limited liability companies, S corporations, and sole 

proprietorships. Both tax and non-tax concerns influence a business’s choice of entity. 

The income of a C corporation is taxed directly to the corporation and distributions of the 

corporation's after-tax income are taxed to the shareholders as dividends, although generally at a 

preferential rate. The income of pass-through entities such as partnerships, limited liability 

companies, and S corporations generally is not taxed at the entity level; instead, items of income 

and loss pass through to the partners or shareholders, who include the items in calculating their 

own taxable income. 

In considering business tax reform, one potential option is to eliminate separate taxation 

and integrate the corporate and individual taxes (often referred to as “corporate integration”). 

Corporate integration would require many significant policy decisions with respect to presentlaw concepts, including the relative tax treatment of debt and equity, whether to pass through 

preferences to shareholders, and whether to ensure collection of at least one level of tax. The 

complex treatment of mergers and acquisitions under present law also could be examined. 

Another area which may be the subject of tax reform proposals is the treatment of cost 

recovery. Cost recovery refers to the process by which a taxpayer recoups the cost of its 

investment in business or other income-producing property. Examples of cost recovery methods 

include straight-line depreciation, accelerated depreciation, and expensing, the latter two of 

which may be used as a tax policy tool to encourage investment. Another form of investment 

incentive is an investment tax credit. 

Tax reform proposals may also arise with respect to the present law international tax 

rules. In a pure worldwide tax system, resident individuals and entities are taxable on their 

worldwide income, regardless of where the income is derived. In a pure territorial tax system, a 

country taxes only income derived within its borders, irrespective of the residence of the 

taxpayer. No country uses a pure worldwide or territorial system. Systems may be accurately 

characterized as predominantly worldwide or territorial, but all systems currently in use share at 

least some features of both approaches. The United States employs a predominantly worldwide 

tax system, under which U.S. persons generally are taxed on all income, whether derived in the 

United States or abroad. 
3 

II. OVERVIEW OF BUSINESS TAXATION 

A. In General 

Businesses may be organized in a number of different ways. Owners of a business 

sometimes conduct their activities as “sole proprietorships,” which do not involve a legal entity 

separate from the owner. However, for a variety of business or other reasons, a business often is 

conducted through a separate legal entity. Common reasons to use a separate legal entity include 

the protection of limited liability accorded by State law to the owners of qualifying entities (but 

generally not to sole proprietors), and an improved ability to access capital markets for 

investment capital. 

The tax consequences of using a separate entity depend on the type of entity through 

which the business is conducted. Partnerships, certain closely-held companies that elect to be 

taxed under subchapter S of the Internal Revenue Code of 1986, as amended (the “Code”), and 

limited liability companies that are treated as partnerships are treated for Federal income tax 

purposes as pass-through entities whose owners take into account the income (whether or not 

distributed) or loss of the entity on their own tax returns. Generally, an entity whose ownership 

interests are publicly traded is not entitled to be treated as a partnership. 

In contrast, the income of a C corporation2

 is taxed directly at the corporate level. 

Shareholders are taxed on dividend distributions of the corporation’s after-tax income. 

Shareholders are also taxed on any gain (including gain attributable to undistributed corporate 

income) on the disposition of their shares of stock of the corporation. Thus, the income of a C 

corporation may be subject to tax at both the corporate and shareholder levels. 3

 2

 A C corporation is a corporation that is subject to subchapter C of the Code, which provides 

rules for corporate and shareholder treatment of corporate distributions and adjustments. C corporations 

generally are subject to the corporate-level tax rate structure set forth in section 11 of the Code. 

3

 Specialized investment entities organized as C corporations, such as regulated investment 

companies and real estate investment trusts, and certain interests in debt instruments, such as real estate 

mortgage investment conduits, are effectively subject to only one level of tax notwithstanding that their 

ownership interests may be publicly traded. These, and other specialized entities such as cooperatives 

and tax-exempt organizations, are beyond the scope of this discussion. 
4 

B. Federal Income Tax Rates 

U.S. individuals (citizens and residents) are taxed at graduated statutory rates ranging 

from 10 percent (for taxable income of up to $7,550 for single filers and up to $15,100 for 

married taxpayers filing joint returns or surviving spouses) to 35 percent (for taxable income 

over $336,550) for taxable year 2006. The intermediate rates are 15 percent, 25 percent, 28 

percent, and 33 percent. The maximum tax rate on net long-term capital gains generally is 15 

percent.4

 Dividends received by an individual from domestic corporations and qualified foreign 

corporations are taxed at the same rates that apply to capital gains.5 

C corporations are taxed at statutory rates ranging from 15 percent (for taxable income up 

to $50,000) to 35 percent (for taxable income over $10,000,000). The intermediate rates are 25 

percent and 34 percent. The benefit of graduated rates below 34 percent is phased out for 

corporations with taxable income between $100,000 and $335,000, and the benefit of the 34 

percent rate is phased out for corporations with taxable income in excess of $15,000,000. 

Corporate long-term capital gains are taxed at the same rates as corporate ordinary income. 

Thus, the maximum tax rate for corporate net long-term capital gains is 35 percent. 

Certain domestic production activities are effectively taxed at lower rates by virtue of a 

deduction equal to a percentage of the income from such activities.6

 The deduction is equal to 

three percent of the income from manufacturing, construction, and certain other activities 

specified in the statute, for taxable years beginning in 2006. The deduction is increased to six 

percent for taxable years beginning in 2007, 2008, and 2009. Thereafter, the deduction is 

increased to nine percent. Thus, when the deduction is fully phased in, the tax rate for a C 

corporation on its domestic production activities income is effectively 31.85 percent.7 A similar 

reduction applies to the graduated rates applicable to individuals. 

In addition, present law imposes a minimum tax on individuals and corporations to the 

extent their minimum tax liability exceeds their regular tax liability. The alternative minimum 

tax (“AMT”) is imposed on corporations at the rate of 20 percent on the alternative minimum 

taxable income (“AMTI”) in excess of a $40,000 phased-out exemption amount. The exemption 

amount is completely phased out for a corporation with AMTI in excess of $310,000. 

 4

 Net gain from the sale of collectibles is taxed at a maximum 28-percent rate, while certain gain 

from the sale or exchange of depreciable real estate (i.e., “unrecaptured section 1250 property”) is taxed 

at a maximum 25 percent rate. Under present law, for taxable years beginning after 2010, the maximum 

tax rate applicable to net long-term capital gains (other than collectibles or unrecaptured section 1250 

property) will increase from 15 percent to 20 percent. 

5

 Under present law, for taxable years beginning after 2010, dividends received by an individual 

are taxed at ordinary income rates. 

6

 Sec. 199. 

7

 Because of the nine-percent deduction, the taxpayer is taxed at a rate of 35 percent on only 91 

percent of income, resulting in an effective tax rate of 31.85 percent. 
5 

A corporation with average gross receipts of less than $7.5 million for the prior three 

taxable years is exempt from the corporate minimum tax. The $7.5 million threshold is reduced 

to $5 million for the corporation’s first three-taxable year period. 

The AMT is imposed on individuals at a rate of 26 percent for the first $175,0008

 of 

AMTI in excess of a phased-out exemption amount and at a rate of 28 percent for amounts in 

excess of such amount. For taxable years beginning in 2006, the exemption amounts are: (1) 

$62,550 in the case of married individuals filing a joint return and surviving spouses; (2) $42,500 

in the case of unmarried individuals other than surviving spouses; and (3) $31,275 in the case of 

married individuals filing a separate return.9 The exemption amount is completely phased out for 

married individuals filing a joint return with AMTI in excess of $400,200. Similar phaseouts 

apply to other individual taxpayers. 

AMTI is the taxpayer’s regular taxable income increased by certain preference items and 

adjusted by determining the tax treatment of certain items in a manner that negates the deferral of 

income resulting from the regular tax treatment of those items. In general, the AMT applies a 

lower tax rate to a broader tax base. Specifically, the regular tax base is increased for AMT 

purposes by adding back certain items treated as tax preferences, and disallowing certain 

deductions and credits. 

 8

 $87,500 in the case of married individuals filing a separate return.

9

 For years beginning after 2006, the exemption amounts are $45,000; $33,750; and $22,500, 

respectively.
6 

C. Choice of Entity 

In general

The choice of business structure can have an impact on the liability of the owners of the 

business, the tax treatment of income and deductions, and on the options available to the 

business for financing projects. In practice, this results in considerable variation in the choice of 

entity structure. For example, in 2003, there were 2.0 million C corporation tax returns, 3.3 

million S corporation tax returns, 2.4 million partnership returns, and 19.7 million non-farm sole 

proprietorship returns. 

C corporations 

A corporation is a business entity organized under a Federal or State statute, or under a 

statute of a Federally recognized Indian tribe, if the statute describes or refers to the entity as 

incorporated or as a corporation.10 The Code taxes a corporation as an entity separate from its 

shareholders. A C corporation’s income generally is taxed when earned at the corporate level 

and is taxed again at the individual level when distributed as dividends11 to its shareholders. 

Corporate deductions and credits reduce only corporate income and are not passed through to 

shareholders. 

Corporate income that is not distributed to shareholders generally is subject to current tax 

at the corporate level only.12 To the extent that income retained at the corporate level is reflected 

in an increased share value, the shareholder may be taxed at capital gains rates upon sale or 

exchange (including certain redemptions) of the stock or upon liquidation of the corporation.13

 10 Treas. Reg. sec. 301.7701-2(b)(1). 

11 Distributions with respect to stock that exceed corporate earnings and profits are not taxed as 

dividend income to shareholders but are treated as a tax-free return of capital that reduces the 

shareholder’s basis in the stock. Distributions in excess of corporate earnings and profits that exceed a 

shareholder’s basis in the stock are treated as amounts received in exchange for the stock which, in 

general, are taxed to the shareholder at capital gains rates. 

12 In addition to the regular corporate tax, the Code provides for an additional tax paid by the 

corporation at the top individual rate, imposed on certain corporate earnings that are not distributed to 

shareholders. An “accumulated earnings tax” can be imposed on certain earnings in excess of $250,000 

($150,000 for certain service corporations in certain fields) accumulated beyond the reasonable needs of 

the business (secs. 531-537). A “personal holding company tax” is imposed on certain undistributed 

personal holding company income, generally where the corporation meets certain closely held stock 

requirements and more than 60 percent of the adjusted ordinary gross income (as defined) consists of 

certain passive-type income such as dividends, interest, and similar items (secs. 541-547). 

13 If stock is held until the death of the shareholder, the stock is given a fair market value basis at 

death, resulting in no shareholder level income tax on appreciation prior to death if the heirs sell the stock 

to a third party, or receive corporate distributions in the form of a redemption–i.e. a sale of their stock to 

the corporation. Present law is scheduled to provide a modified carryover basis rule in the case of estates 

of decedents dying in the year 2011. 
7 

Foreign investors generally are exempt from U.S. income tax on capital gains, but are subject to 

withholding tax on dividends. Tax-exempt investors are not generally subject to tax on corporate 

distributions or on sales or exchanges of corporate stock. 

The gain on appreciated corporate assets is generally subject to corporate level tax if they 

are distributed to the shareholders, yielding the same tax result as if the assets had been sold by 

the corporation and the proceeds distributed to the shareholders. 

In general, amounts paid as reasonable compensation to shareholders who are also 

employees are deductible by the corporation,14 and are taxed as ordinary income at the individual 

level (unless a specific exclusion applies). On the other hand, amounts paid as dividends to 

shareholders generally are not deductible by the corporation and are taxed as income to the 

shareholders (generally at the same preferential rates as apply to capital gains, for dividends 

received prior to 2011). However, amounts paid to corporate shareholders as dividends are 

generally eligible for a dividends-received deduction for the recipient corporation that results in 

the recipient corporation being taxed on at most 70 percent and possibly on none of the dividend 

received.15

In general, interest paid by a C corporation is deductible but dividends paid are not.16 

This creates a tax incentive that generally favors debt over equity in a corporation’s capital 

structure. However, in some situations equity may be preferred to debt. Shareholders of a C 

corporation receive different treatment depending upon whether an instrument is characterized as 

equity or debt for tax purposes.17 The corporate dividends-received deduction and the dividend 

rate reduction for dividends received by individuals may provide shareholder incentives to invest 

in stock rather than debt. An issuing corporation with losses may prefer to issue preferred stock 

 14 Annual compensation in excess of $1 million that is payable to the chief executive officer or 

the four other most highly compensated employees of a public corporation is not deductible unless the 

compensation qualifies as performance-based compensation or another exception applies. Sec. 162(m). 

15 The recipient corporation can generally claim a 100 percent dividends-received deduction if 

the recipient corporation owns 80 percent or more of the distributing corporation. If the recipient 

corporation owns less than 80 percent but at least 20 percent of the distributing corporation, the 

dividends-received deduction is 80 percent. If the recipient corporation owns less than 20 percent of the 

distributing corporation, the dividends-received deduction is 70 percent. There is no corporate exclusion 

with respect to interest received. 

16 If certain requirements are satisfied, dividends paid on stock held by an employee stock 

ownership plan are deductible by the corporation. Sec. 404(k). 

17 Debt and equity investments also provide different consequences to certain investors in the 

pass-through regimes of partnerships and S corporation. For example, tax-exempt and foreign investors 

are generally not taxed on interest income from a partnership if they are debt investors, but generally 

would be taxed in their share of partnership income from business activity of the partnership if they are 

equity investors. The subchapter S rules do not permit foreign investors or certain tax-exempt investors 

to own stock of an S corporation. Those tax-exempt investors that may own S corporation stock are 

subject to an unrelated business income tax on their share of S corporation income. These factors can 

lead to a preference for structuring partnership or S corporation investment by such investors as debt. 
8 

with characteristics similar to debt, effectively passing through some of the benefit of its losses 

to shareholders.18 Foreign shareholders may prefer either dividend or interest income, depending 

on the tax treatment in their country of residence and the applicable U.S. tax withholding rates. 

The distinction between debt and equity depends on a number of factors. This 

determination requires an examination of the substance of the instrument. Generally, debt 

requires a promise to pay a fixed sum by a date certain, with a reasonable expectation that 

payment is made. Debt instruments can be constructed to have features of both debt and equity, 

including (1) contingent payments up to a high yield or (2) a significant economic risk that all 

payments may not be made. Similarly, equity instruments can be constructed to have features of 

debt, including dividend incentives or put-call arrangements under which the issuer is expected 

to pay specified dividends and return the initial investment by a date certain.19 Section 385 

authorizes the Treasury Department to issue rules distinguishing debt from equity. Several sets 

of regulations have been proposed, but none has been finalized and retained. 

The analysis of whether an instrument is debt or equity for Federal income tax purposes 

is not identical to the analysis of whether such instrument is characterized as debt or equity for 

financial reporting purposes. As a result, financial instruments are sometimes specifically 

structured to obtain desired differing treatment for tax and financial reporting purposes. 

Shareholders receive different treatment depending on whether a corporate equity 

distribution is characterized as a dividend or as a payment in exchange for stock that is entitled to 

both capital gain treatment and basis recovery. While the tax rates for dividends and capital 

gains on stock are generally the same under present law, capital gain treatment permits basis 

 18 Distributions to shareholders by a loss corporation are taxed as dividends, with accompanying 

dividend treatment to shareholders, if the loss corporation had prior year earnings and profits that have 

not yet been distributed. If all earnings and profits have been distributed, distributions to shareholders 

would be nontaxable return of capital distributions, reducing the shareholders’ basis in the stock. 

19 The Code limits the corporate interest deduction in specified situations. The Code provisions 

are based in part on case-law factors that distinguish debt from equity, but each Code provision turns on 

different facts and is narrowly applied to specific situations. The provisions include the following 

sections of the Code: Section 163(i) denies interest deductions on certain high-yield19 deferred payment 

discount obligations. The disallowed portion is treated as a dividend. Section 163(j) denies interest 

deductions for certain payments to tax-exempt related parties that exceed 50 percent of income if there is 

a greater than 1.5 to 1 debt equity ratio. A carryover is allowed. Section 163(l) denies interest deductions 

on certain debt if a substantial amount of the principal or interest of the debt is payable in, or determined 

by reference to, equity of the issuer at the option of the issuer or a related party. The rules also apply if 

the choice to receive equity or amounts determined by reference to equity is at the option of the holder of 

the debt or a related party, if there is “substantial certainty” that the option will be exercised. Section 

172(h) denies net operating loss carrybacks attributable to interest after certain corporate equity reduction 

transactions (generally, if there has been an acquisition of 50 percent of corporate stock, or an “excess” 

distribution). Carryforwards are allowed. Section 279 denies interest deductions for certain narrowly 

defined “corporate acquisition indebtedness.” 
9 

recovery.20 A number of Code provisions have attempted to provide guidance in this area. For 

example, section 302 provides rules to determine whether a shareholder whose stock has been 

partially redeemed has experienced a sufficient contraction in his or her interest to be treated as 

having sold the stock rather than as having received a dividend. Section 304 provides additional 

rules intended to deal with sales of stock to commonly controlled corporations. 

An affiliated group of corporations may elect to file a consolidated return in lieu of 

separate returns.21 A condition of electing to file a consolidated return is that all corporations 

that are members of the affiliated group must consent to all the consolidated return regulations 

prescribed prior to the last day prescribed by law for filing the consolidated return. The Treasury 

department has issued extensive consolidated return regulations under its authority to provide 

such rules. The regulations are generally directed toward preventing double taxation of income 

earned within the group, while preserving tax if assets or corporations that were members leave 

the group and preventing avoidance of tax due to shifting of attributes in the course of intragroup 

transactions.22 

A C corporation is generally the entity of choice if a corporation anticipates a public 

offering, because publicly traded partnerships are generally taxed as corporations, and S 

corporations (discussed below) are not permitted to have more than 100 shareholders.23

 20 Foreign shareholders, in addition, may not be subject to tax at all on capital gains, though they 

are taxed (often at a reduced rate under tax treaties) on dividends. On the other hand, some corporate 

shareholders may prefer dividend treatment if they are eligible for the dividends-received deduction. 

21 An affiliated group for this purpose includes a parent corporation that directly owns 80 percent 

of the vote and value of the stock (excluding certain nonvoting preferred stock) of at least one subsidiary 

(causing that subsidiary to be a qualified member of the group) and other corporations of which qualified 

upper tier members in turn hold such stock ownership. Foreign corporations and certain other entities are 

not eligible to be members of such a group. 

22 Section 1502 of the Code states that “The Secretary shall prescribe such regulations as he may 

deem necessary in order that the tax liability of any affiliated group of corporations making a consolidated 

return and of each corporation in the group, both during and after the period of affiliation, may be 

returned, determined, computed, assessed, collected, and adjusted in such manner as clearly to reflect the 

income-tax liability and the various factors necessary for the determination of such liability, and in order 

to prevent the avoidance of such tax liability. In carrying out the preceding sentence, the Secretary may 

prescribe rules that are different from the provisions of chapter 1 that would apply if such corporations 

filed separate returns.” 

23 In some circumstances, it is possible that non-publicly traded entities also might choose to 

operate as C corporations, for example in order to obtain the benefit of a separate corporate rate bracket or 

the benefit of special corporate treatment (e.g., the dividends-received deduction) for earnings that are to 

be retained in the corporation. Appreciation in corporate assets generally is subject to corporate level tax 

when the assets are distributed to shareholders; and there is no lower rate for corporate capital gains. 

These factors generally would be a deterrent to placing assets into a C corporation. Nevertheless, there 

may be situations where lower effective corporate rates could provide benefits. 
10 

Partnerships

Pass-through treatment

Business owners may choose to operate or invest through a “pass-through” entity, such as 

a partnership, limited liability company, or S corporation, either to avoid corporate tax treatment 

or for non-tax business reasons. Noncorporate tax treatment may be preferred because: (1) 

owners may not wish business earnings to be subject to two levels of tax (once when earned, and 

again when distributed); (2) the average or marginal tax rates for the individual shareholders may 

be lower than that of the corporation; and (3) owners may wish to use losses generated by the 

business to offset income from other sources. 

Federal income tax treatment of partnerships

Partnerships generally are treated for Federal income tax purposes as pass-through 

entities, not subject to tax at the entity level.24 Items of income (including tax-exempt income), 

gain, loss, deduction and credit of the partnership are taken into account in computing the tax of 

the partners (based on the partnership’s method of accounting and regardless of whether the 

income is distributed to the partners). Each partner takes into income such partner’s distributive 

share of the partnership’s taxable income and the separately allocable items of income, gain, 

loss, deduction, and credit.25 A partner’s deduction for partnership losses is limited to the 

amount of the partner’s adjusted basis in his or her partnership interest.26 To the extent a loss is 

not allowed due to a limitation, it generally is carried forward to the next year. A partner’s basis 

in the partnership interest generally equals the sum of (1) such partner’s capital contribution to 

the partnership, (2) the partner’s distributive share of partnership income, and (3) the partner’s 

share of partnership liabilities, less (1) such partner’s distributive share of losses allowed as a 

deduction and (2) any partnership distributions.27

Partnerships provide partners with a significant amount of flexibility to vary their 

respective shares of partnership income. Unlike corporations, partnerships may allocate items of 

income, gain, loss, deduction and credit among the partners, provided the allocations have 

substantial economic effect. In general, an allocation is permitted to the extent the partner to 

which the allocation is made receives the economic benefit or bears the economic burden of such 

allocation, and the allocation substantially impacts the dollar amounts to be received by the 

partners from the partnership independent of tax consequences. 

 24 Sec. 701. 

25 Sec. 702(a). The recognition of income under this rule does not necessarily correspond with 

any distribution of cash from the partnership to cover the tax liabilities of individual partners. 

26 Sec. 704(d). In addition, “passive loss” and “at-risk” limitations limit the extent to which 

certain types of income can be offset by partnership deductions. These limitations do not apply to 

corporate partners (except certain closely held corporations) and may not be important to individual 

partners who have partner level “passive income” from other investments. 

27 Sec. 705. 
11 

Limited liability companies

In the last 30 years,28 States have enacted laws providing for another form of entity, the 

limited liability company (“LLC”). LLCs are generally treated as partnerships for Federal 

income tax purposes. They are neither partnerships nor corporations under applicable State law, 

but they generally provide limited liability to their owners for obligations of the business. Under 

regulations promulgated in 1996, any domestic non-publicly traded unincorporated entity with 

two or more members generally may elect to be treated as either a partnership or a corporation 

for Federal income tax purposes, while any single-member unincorporated entity may elect to be 

treated as a corporation or to be disregarded (i.e., treated as not separate from its owner29) for 

Federal income tax purposes.30 These regulations, known as the “check-the-box” regulations, 

were a response, in part, to the growth of LLCs. 

S corporations

An S corporation provides the Federal income tax advantage of pass-through treatment, 

and also retains the non-tax advantages of corporate status under Federal securities laws and 

State law. An S corporation and its shareholders are generally treated, for Federal income tax 

purposes, more like a partnership and its partners than like a C corporation and its shareholders. 

In order to make an election to be treated as an S corporation, a corporation must meet certain 

requirements primarily regarding its capital structure and the identity of its shareholders. 

To be eligible to elect S corporation status, a corporation may not have more than 100 

shareholders and may not have more than one class of stock. Only individuals (other than 

nonresident aliens), certain tax-exempt organizations, and certain trusts and estates are permitted 

shareholders. A corporation may elect S corporation status only with the consent of all its 

shareholders, and may terminate its election with the consent of shareholders holding more than 

50 percent of the stock.31 Although there are limitations on the types of shareholders and stock 

structure an S corporation may have, there is no limit on the asset size of such a corporation (as 

there is no limit on the size of a C corporation or partnership). 

For Federal income tax purposes, an S corporation is generally not subject to tax at the 

corporate level.32 Items of income (including tax-exempt income), gain, loss, deduction and 

credit of the corporation are taken into account in computing the tax of the shareholders (under 

the corporation’s method of accounting and regardless of whether the income is distributed to the 

 28 The first LLC statute was enacted in Wyoming in 1977. All States (and the District of 

Columbia) now have an LLC statute, though the tax treatment of LLCs for State tax purposes may differ. 

29 Thus, where the single member is an individual, such a disregarded LLC will be treated as a 

sole proprietorship. Where the single member is a corporation, the LLC will be treated as a branch. 

30 Treas. Reg. sec. 301.7701-3. 

31 Sec. 1362. 

32 Secs. 1363 and 1366. 
12 

shareholders). A shareholder’s deduction for corporate losses is limited to the sum of the 

shareholder’s adjusted basis in the S corporation stock and the indebtedness of the corporation to 

such shareholder. To the extent a loss is not allowed due to this limitation, the loss generally is 

carried forward to the next year. The shareholder’s basis in the S corporation stock (and debt) is 

reduced by the shareholder’s share of losses and (in the case of stock) by distributions and is 

increased by the shareholder’s share of the corporation’s income and contributions to capital.33 

There are two principal exceptions to the general pass-through treatment of S 

corporations. Both are applicable only if the corporation was previously a C corporation and are 

generally intended to prevent avoidance of otherwise applicable C corporation tax consequences. 

First, an S corporation is subject to tax on excess net passive investment income (but not in 

excess of its taxable income, subject to certain adjustments), if the corporation has subchapter C 

earnings and profits and has gross receipts more than 25 percent of which are passive investment 

income for the year.34 Second, for the first 10 years after a corporation that was previously a 

regular C corporation elects to be an S corporation, certain net “built-in” capital gains of the 

corporation attributable to the period in which it was a C corporation are subject to tax at the 

corporate level.35

In general, an S corporation shareholder is not subject to tax on corporate distributions 

unless the distributions exceed the shareholder’s basis in the stock of the corporation or the 

corporation was formerly a C corporation and has undistributed earnings and profits.36 To the 

extent of such earnings and profits, corporate distributions are treated as dividends of C 

corporations and generally are subject to tax as such in the hands of the shareholders. 

Comparison of pass-through entities

Notwithstanding that they both provide for pass-through treatment, there are several 

significant Federal tax differences between S corporations and partnerships. First, corporate 

liabilities (other than those owed to its shareholders) are not included in a shareholder’s basis of 

their interest in an S corporation. Thus, unlike a partner who can take deductions supported by 

certain partnership indebtedness, S corporation shareholders who wish to obtain similar types of 

deductions are required to individually borrow and contribute or re-lend such amounts to the S 

corporation. Further, S corporations may have only one class of stock and, thus, do not offer the 

 33 Sec. 1367. 

34 Sec. 1375. C corporation earnings and profits generally refers to the earnings of the 

corporation prior to its subchapter S election which would have been taxable as dividends if distributed to 

shareholders by the corporation prior to its subchapter S election. If the S corporation continues to have 

C corporation earnings and profits and has gross receipts more than 25 percent of which are passive 

investment income in each year for three consecutive years, the S corporation election is automatically 

terminated (sec. 1362(d)(3)). 

35 Sec. 1374. 

36 Sec. 1368. 
13 

same flexibility as partnerships to allocate income and losses to different investors. Below is a 

list of the major differences in the taxation of the two types of entities and their owners: 
Table 1.–Major Differences in Taxation of Partnerships and S Corporations 

Item Partnerships S Corporatio

Maximum number of equity interests No maximum number. (Partnerships 

with over 100 partners may elect a special pass-thru regime.) 

Maximum number of shareholders is 100

Classes of equity interests No limitation. One class of stock. (Voting rights disreg

determination.) 

Ineligible entities Generally, partnerships with equity 

interests that are publicly traded. 

Financial institutions using reserve methocompanies; possessions corporations; DI

Eligible shareholders All persons eligible. Eligible shareholders include individuals

charities, and qualified retirement plans. 

Foreign taxpayers Eligible to be a partner; effectively 

connected income subject to withholding tax. 

Ineligible to be a shareholder. 

Tax-exempt taxpayers Eligible to be a partner; income subject 

to generally applicable unrelated business income tax 

Tax-exempt taxpayers (other than charitiplans) ineligible to be a shareholder; all icharities and qualified retirement plans (ounrelated business taxable income; items not included in unrelated business taxabl

Trusts Eligible to be a partner; usual trust 

taxation rules apply. 

Only qualified subchapter S trusts and eleeligible as shareholders; special taxation 

Allocation of income and losses Allocation in accordance with 

partnership agreement so long as allocation has substantial economic effect. 

Pro rata among shares on a daily basis. 

Limitation on losses Losses limited to basis in partnership 

interest, which includes partner’s share of partnership debt. 

Losses limited to basis in stock and indebshareholder; no inclusion of corporate de

Contributions of property Tax-free; built-in gain or loss allocated 

to contributing partner. 

Tax-free (if control requirement met); no 

14 
Item Partnerships S Corporatio

Distributions of property (liquidating or otherwise) 

Generally tax-free; carryover or substituted basis to partner; partnership may elect to make basis adjustment in partnership property to reflect adjustments to distributee partner. 

Gain taxed to corporation; fair market vabasis adjustments to corporate property. 

Transfer of equity interests Gain treated as ordinary income to 

extent of ordinary income on assets held by partnership; partnership may elect to adjust basis of its assets with respect to transferee partner to reflect purchase price. 

No ordinary income look-thru provision; corporate property. 

Termination of entity Termination if sale or exchange of 50 

percent or more of partnership interests within 12 months. 

No provision. 

Treatment of C corporation converting to partnership or S corporation. 

Corporation must liquidate and gain or loss is recognized to corporation and shareholders. 

Generally no taxation upon election; corpin gain if assets sold during 10 year periodistribution of subchapter C earnings and special rules applicable to a corporation wand excess net passive investment incom

Mergers, etc. with corporations Not eligible to engage in tax-free 

reorganization with corporation. 

Eligible party to a tax-free corporate reor

Corporate tax rules of subchapter C Rules inapplicable. Rules generally applicable. Application of employment taxes Except in the case of a limited partner, 

each partner’s share of net business income is net earnings from selfemployment. 

Amounts paid as compensation are wageearnings from self-employment. 

15 
16

III. DATA ON THE NUMBER AND SIZE OF BUSINESS ENTITIES 

IN THE UNITED STATES 

Trends in use of business entities, 1978-2003

Returns filed by C corporations, S corporations, partnerships, non-farm sole 

proprietors, and farming enterprises

Figure 1 and Table 1 show data from the Internal Revenue Service's Statistics of Income 

(“SOI”) regarding the number of tax returns filed by different forms of business organizations 

from 1978 to 2003.37 In these data, farms are measured solely by reference to those taxpayers 

who report income (or loss) on Schedule F of Form 1040. Other taxpayers engaged in 

agricultural enterprises may use a separate entity. When this occurs, the data reported below 

report that entity among the totals of C corporations, S corporations, or partnerships. 

Throughout the period 1978 to 2003, nonfarm sole proprietorships made up the vast 

majority of businesses. The S corporation is the second most numerous business form. In 2003, 

S corporations constituted 11.3 percent of all business entities. Over the past two decades S 

corporations have grown from approximately 3.5 percent of all business entities to over 10 

percent. The growth in the number of S corporations was most dramatic immediately following 

1986, while the number of C corporations and partnerships declined each year from 1987 

through 1993. The number of farm returns generally declined through the 25-year period. 

 37 These data are based upon returns filed by individuals and entities. The numbers reported for 

nonfarm sole proprietorships and for farm returns are based upon the number of taxpayers who file a 

business return as a sole proprietor (Schedule C to Form 1040) and who file a farm income return 

(Schedule F to Form 1040). One taxpayer may report more than one business organized as a sole 

proprietorship; the data reported here count only one sole proprietorship. On the other hand, the data for 

C corporations, S corporations, and partnerships count the number of tax returns and information returns 

filed by C corporations, S corporations, and partnerships. One taxpayer may own more than one 

corporation. When this occurs, unlike the case in sole proprietorships, the data reported here count each 

corporation as a separate entity. Thus, the data are not perfectly comparable across entity classification. 
17

Figure 1.–Number of Different Types of Business Returns,

1978-2003

0

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

19781979198019811982198319841985198619871988198919901991199219931994199519961997199819992000200120022003

Year

Number of Business Entities

Nonfarm sole props

C Corps

S Corps

Partnerships

Farms (Schedule F)

Source: Internal Revenue Service, Statistics of Income, published and unpublished data.
18

Sole C S

Year Proprietorships Corporations Corporations Partnerships Farms Total

1978 8,908,289 1,898,100 478,679 1,234,157 2,704,794 15,224,019

1979 9,343,603 2,041,887 545,389 1,299,593 2,605,684 15,805,674

1980 9,730,019 2,165,149 545,389 1,379,654 2,608,430 16,428,641

1981 9,584,790 2,270,931 541,489 1,460,502 2,641,254 16,498,966

1982 10,105,515 2,361,714 564,219 1,514,212 2,689,237 17,234,897

1983 10,703,921 2,350,804 648,267 1,541,539 2,710,044 17,954,575

1984 11,262,390 2,469,404 701,339 1,643,581 2,694,420 18,771,134

1985 11,928,573 2,552,470 724,749 1,713,603 2,620,861 19,540,256

1986 12,393,700 2,602,301 826,214 1,702,952 2,524,331 20,049,498

1987 13,091,132 2,484,228 1,127,905 1,648,035 2,420,186 20,771,486

1988 13,679,302 2,305,598 1,257,191 1,654,245 2,367,527 21,263,863

1989 14,297,558 2,204,896 1,422,967 1,635,164 2,359,718 21,920,303

1990 14,782,738 2,141,558 1,575,092 1,553,529 2,321,153 22,374,070

1991 15,180,722 2,105,200 1,696,927 1,515,345 2,290,908 22,789,102

1992 15,495,419 2,083,652 1,785,371 1,484,752 2,288,218 23,137,412

1993 15,848,119 2,063,124 1,901,505 1,467,567 2,272,407 23,552,722

1994 16,153,871 2,318,614 2,023,754 1,493,963 2,242,324 24,232,526

1995 16,423,872 2,321,048 2,153,119 1,580,900 2,219,244 24,698,183

1996 16,955,023 2,326,954 2,304,416 1,654,256 2,188,025 25,428,674

1997 17,176,486 2,257,829 2,452,254 1,758,627 2,160,954 25,806,150

1998 17,398,440 2,260,757 2,588,081 1,855,348 2,091,845 26,194,471

1999 17,575,643 2,210,129 2,725,775 1,936,919 2,067,883 26,516,349

2000 17,902,791 2,184,795 2,860,478 2,057,500 2,086,789 27,092,353

2001 18,338,190 2,149,105 2,986,486 2,132,117 2,006,871 27,612,769

2002 18,925,517 2,112,230 3,154,377 2,242,169 1,995,072 28,429,365

2003 19,710,079 2,059,631 3,341,606 2,375,375 1,997,116 29,483,807

Source: Internal Revenue Service, Statistics of Income, published and unpublished data.

Table 2.–Number of Different Types of Business Returns Relative to

All Business Returns, 1978-2003

The growth of limited liability companies

The use of the limited liability company (“LLC”) as an entity is a development of the past 

decade. Most LLCs filed the partnership reporting form for Federal reporting purposes and their 

numbers, assets, and gross receipts are counted among the partnership data reported in Table 1 

and Figure 1 above. Table 3 and Figure 2, below, decompose the number of partnerships for the 

period 1990 through 2003 into general partnerships, limited partnerships, and LLCs.38 Figure 5 

 38 The data in Table 2 may not sum to the total number of partnerships reported in Table 1 

because of rounding. Also, this decomposition exclude those businesses that checked either the “limited 

liability partnership” box, the “other” box, or those partnerships that identified themselves as foreign 

partnerships on Form 1065, Schedule B, line 1. See, Alan Zempel, “Partnership Returns, 1998,” SOI 

Bulletin, 20, Fall 2000, Bill Pratt, “Partnership Returns, 2000,” SOI Bulletin, 22, Fall 2002, and Tim 

Wheeler and Nina Shumofsky, “Partnership Returns, 2003,” SOI Bulletin, 25, Fall 2005. 
19

documents the rapid growth of LLCs relative to other partnership forms over the past several 

years. Since 1996, LLCs have grown at a rate of approximately 25 percent per year. 

Table 3.–Number of Partnership Returns by Type, 1990-2003 

Type of Partnership 

Year 

General 

Partnerships 

(thousands) 

Limited 

Partnerships 

(thousands) 

Limited Liability 

Companies 

(thousands) 

1990 1,267 285 n.a. 

1991 1,245 271 n.a. 

1992 1,214 271 n.a. 

1993 1,176 275 17 

1994 1,163 283 48 

1995s 1,167 295 119 

1996 1,116 311 221 

1997 1,069 329 349 

1998 945 343 470 

1999 898 354 589 

2000 872 349 719 

2001 815 369 809 

2002 780 377 946 

2003 757 379 1,092 

n.a. - not available. 

Source: Bill Pratt, “Partnership Returns, 2000,” SOI Bulletin, 22, Fall 2002 Tim Wheeler and Nina 

 Shumofsky, “Partnership Returns, 2003,” SOI Bulletin, 25, Fall 2005. 
20

Figure 2.–Partnership Returns by Type of Partnership,

1989-2003

0

200

400

600

800

1,000

1,200

1,400

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Year

Thousands

General Partnership

Limited Partnership

Limited Liability

Companies

Source: Bill Pratt, “Partnership Returns, 2000,” SOI Bulletin, 22, Fall 2002 Tim Wheeler and Nina Shumofsky, 

 “Partnership Returns, 2003,” SOI Bulletin, 25, Fall 2005. 

Size distribution of C corporations, S corporations, partnerships, and non-farm sole 

proprietorships

While one may often associate small businesses with organization in the form of a sole 

proprietorship, a partnership, or an S corporation, there is not an ironclad correspondence 

between the size of the business and the form of organization. While many small businesses are 

arranged as a sole proprietorship, a partnership, or an S corporation, not all businesses organized 

in those forms are small and not all businesses organized as C corporations are large. One can 

use SOI data on assets and gross receipts to measure the size of businesses in order to sort out 

how small businesses are arrayed across the different forms of organization. 

Tables 4 through 7 display 2003 SOI data on C corporations, S corporations, 

partnerships, and nonfarm sole proprietorships. For the first three forms of organization, the 

tables classify all taxpayers using that form of organization both by the size of assets and gross 

receipts. For sole proprietorships (Table 6), there is no tax data on assets, so the table uses only 

gross receipts as a classifier. When businesses are classified by asset size, one can see that there 

are a significant number of C corporations of small size. More than 850,000 corporations have 

assets under $50,000, approximately 40 percent of the total number of C corporations. For S 

corporations, approximately one half have assets under $50,000. 
21

The concentration of assets differs among the three entity forms. C corporations have the 

largest disparity in asset holding. Firms with over $100 million in assets, which represent 0.9 

percent of all C corporations, hold 96 percent of the assets in C corporations. By comparison, 

partnerships with $100 million or more in assets constitute 0.4 percent of all partnerships and 

these businesses own only 67 percent of all assets owned by partnerships. S corporations with 

$100 million or more in assets constitute only 0.06 percent of all S corporations and account for 

26 percent of all assets owned by S corporations. 

When businesses are classified by gross receipts, a picture emerges that is similar to that 

seen in the asset data. There are a substantial number of quite small C corporations (more than 

450,000 corporations with gross receipts less than $25,000, nearly 23 percent of the number of C 

corporations). But across the other forms of organization there are higher percentages of 

businesses with small amounts of gross receipts. For nonfarm sole proprietorships, 68 percent 

have gross receipts under $25,000. For S corporations, 25 percent report gross receipts of 

$25,000 or less. 

As with assets, the dispersion of gross receipts across the classifications is more skewed 

for C corporations and partnerships than for S corporations. C corporations with over $50 

million in gross receipts, which represent approximately 0.73 percent of all C corporations, 

collect over 80 percent of gross receipts of all C corporations. For partnerships, approximately 

the 0.2 percent of partnerships with gross receipts in excess of $50 million report 67 percent of 

all partnership gross receipts. For S corporations, 0.3 percent of S corporations with gross 

receipts in excess of $50 million report 30 percent of S corporation gross receipts. For non-farm 

sole proprietorships, fewer than 0.001 percent of such businesses report gross receipts in excess 

of $50 million, and these businesses report less than two percent of all non-farm sole 

proprietorship gross receipts. 
22

Cumulative Percent

Firms classified by assets

Number of

Returns

Total Assets 

(millions) Returns Total Assets

$0 or less 225,406 0 10.94% 0.00%

$1 to $25,000 451,718 3,461 32.88% 0.01%

$25,001 to $50,000 191,802 6,491 42.19% 0.02%

$50,001 to $100,000 235,533 16,064 53.62% 0.05%

$100,001 to $250,000 327,419 52,150 69.52% 0.15%

$250,001 to $500,000 215,538 76,577 79.99% 0.30%

$500,001 to $1,000,000 157,822 111,309 87.65% 0.52%

$1,00,001 to $10,000,000 201,051 555,141 97.41% 1.60%

$10,000,001 to $50,000,000 27,933 609,856 98.77% 2.78%

$50,000,001 to $100,000,000 6,839 486,576 99.10% 3.73%

More than $100,000,000 18,570 49,540,577 100.00% 100.00%

Total 2,059,631 51,458,202

Cumulative Percent

Firms classified by receipts

Number of 

Returns

Total Receipts 

(millions) Returns Total Receipts

$0 or less 245,523 -283 11.92% 0.00%

$1 to $2,500 48,411 50 14.27% 0.00%

$2,501 to $5,000 30,490 113 15.75% 0.00%

$5,001 to $10,000 40,057 300 17.70% 0.00%

$10,001 to $25,000 103,902 1,735 22.74% 0.01%

$25,001 to $50,000 125,957 4,637 28.86% 0.04%

$50,001 to $100,000 179,644 13,421 37.58% 0.14%

$100,001 to $250,000 326,671 53,945 53.44% 0.51%

$250,001 to $500,000 267,119 96,492 66.41% 1.17%

$500,001 to $1,000,000 245,357 173,069 78.32% 2.35%

$1,000,001 to $10,000,000 384,193 1,102,312 96.97% 9.91%

$10,000,001 to $50,000,000 47,284 960,598 99.27% 16.49%

More than $50,000,000 15,023 12,182,314 100.00% 100.00%

Total 2,059,631 14,588,703

Table 4.–Distribution of C Corporations, 2003

* Details do not add to total due to rounding. 
23

Cumulative Percent

Firms classified by assets

Number of 

Returns

Total Assets 

(millions) Returns Total Assets

$0 or less 399,425 0 11.95% 0.00%

$1 to $25,000 941,803 7,608 40.14% 0.35%

$25,001 to $50,000 377,169 12,827 51.42% 0.93%

$50,001 to $100,000 409,527 28,768 63.68% 2.25%

$100,001 to $250,000 479,170 75,059 78.02% 5.68%

$250,001 to $500,000 289,998 102,812 86.70% 10.38%

$500,001 to $1,000,000 185,017 128,551 92.23% 16.26%

$1,00,001 to $10,000,000 231,258 638,129 99.15% 45.45%

$10,000,001 to $50,000,000 23,881 463,027 99.87% 66.62%

$50,000,001 to $100,000,000 2,438 167,966 99.94% 74.31%

More than $100,000,000 1,920 561,836 100.00% 100.00%

Total 3,341,606 2,186,583

Cumulative Percent

Firms classified by receipts

Number of 

Returns

Total Receipts 

(millions) Returns Total Receipts

$0 or less 464,406 -763 13.90% -0.02%

$1 to $2,500 85,361 96 16.45% -0.02%

$2,501 to $5,000 40,381 153 17.66% -0.01%

$5,001 to $10,000 75,469 566 19.92% 0.00%

$10,001 to $25,000 165,633 2,799 24.88% 0.07%

$25,001 to $50,000 218,687 8,011 31.42% 0.26%

$50,001 to $100,000 341,945 25,321 41.65% 0.87%

$100,001 to $250,000 601,343 98,337 59.65% 3.23%

$250,001 to $500,000 451,434 162,104 73.16% 7.13%

$500,001 to $1,000,000 374,646 266,141 84.37% 13.52%

$1,000,001 to $10,000,000 459,793 1,243,554 98.13% 43.39%

$10,000,001 to $50,000,000 52,777 1,101,059 99.71% 69.85%

More than $50,000,000 9,731 1,255,170 100.00% 100.00%

Total 3,341,606 4,162,548

Table 5.–Distribution of S Corporations, 2003

* Details do not add to total due to rounding.
24

Cumulative Percent

Firms classified by assets

Number of 

Returns

Total Assets 

(millions) Returns Total Assets

$0 or less 653,446 -59,510 27.51% -0.62%

$1 to $25,000 272,468 2,242 38.98% -0.59%

$25,001 to $50,000 111,953 4,070 43.69% -0.55%

$50,001 to $100,000 131,916 9,686 49.25% -0.45%

$100,001 to $250,000 258,981 43,267 60.15% 0.00%

$250,001 to $500,000 227,650 82,588 69.73% 0.85%

$500,001 to $1,000,000 231,739 167,153 79.49% 2.58%

$1,00,001 to $10,000,000 413,173 1,225,312 96.88% 15.24%

$10,000,001 to $50,000,000 56,917 1,149,937 99.28% 27.13%

$50,000,001 to $100,000,000 7,732 544,931 99.60% 32.76%

More than $100,000,000 9,400 6,505,377 100.00% 100.00%

Total 2,375,375 9,675,053

Cumulative Percent

Firms classified by receipts

Number of 

Returns

Total Receipts 

(millions) Returns Total Receipts

$0 or less 1,465,925 0 61.71% 0.00%

$1 to $2,500 56,996 56 64.11% 0.00%

$2,501 to $5,000 33,107 118 65.51% 0.01%

$5,001 to $10,000 44,948 316 67.40% 0.02%

$10,001 to $25,000 78,718 1,311 70.71% 0.07%

$25,001 to $50,000 84,049 3,111 74.25% 0.19%

$50,001 to $100,000 101,523 7,542 78.53% 0.48%

$100,001 to $250,000 159,177 26,273 85.23% 1.49%

$250,001 to $500,000 109,916 39,210 89.85% 3.01%

$500,001 to $1,000,000 89,370 62,959 93.62% 5.44%

$1,000,001 to $10,000,000 129,550 362,599 99.07% 19.42%

$10,000,001 to $50,000,000 17,057 357,156 99.79% 33.20%

More than $50,000,000 5,039 1,731,694 100.00% 100.00%

Total 2,375,375 2,592,346

Table 6.–Distribution of Partnerships, 2003

* Details do not add to total due to rounding. 
25

Number of Total Receipts

Firms classified by receipts Returns (millions) Returns Total Receipts

$0 or less 845,281 0 4.29% 0.00%

$1 to $2,500 3,865,401 4,523 23.90% 0.44%

$2,501 to $5,000 2,221,661 8,053 35.17% 1.21%

$5,001 to $10,000 2,793,606 20,277 49.35% 3.17%

$10,001 to $25,000 3,679,544 59,269 68.01% 8.89%

$25,001 to $50,000 2,416,372 85,911 80.27% 17.17%

$50,001 to $100,000 1,775,671 126,018 89.28% 29.33%

$100,001 to $250,000 1,361,294 208,563 96.19% 49.45%

$250,001 to $500,000 457,951 158,382 98.51% 64.72%

$500,001 to $1,000,000 197,727 133,870 99.52% 77.64%

$1,000,001 to $10,000,000 93,816 185,477 99.99% 95.53%

$10,000,001 to $50,000,000 1,593 27,889 100.00%1 98.22%

More than $50,000,000 162 18,476 100.00% 100.00%

Total 19,710,079 1,036,708

Table 7.–Distribution of Nonfarm Sole Proprietorships, 2003

Cumulative Percent

* Details do not add to total due to rounding. 

Note: The actual figure is 99.9992 percent which rounds to 100.00 percent. 
26

IV. CORPORATE INTEGRATION 

A. Background and Issues 

The present law structure of a separate entity level tax on corporate income has long been 

recognized to create a variety of economic distortions. The two levels of tax on corporate form 

income (entity and individual level), as compared to the single individual level tax imposed on 

pass-through entities (S-corps, partnerships, LLCs), create a bias against the corporate form of 

organization; this in turn limits investors’ access to publicly traded equity investment, which may 

impose a particular burden to smaller investors who are less likely to have significant access to 

equity investments in pass-through entities. To the extent that the two levels of tax impose a 

higher level of tax on investment generally, the incentive to save is reduced. The resulting 

increase in the cost of capital needed to finance new investment will lead to lower capital 

formation, thereby reducing future output and productivity. An additional distortion resulting 

from the present law corporate income tax rules is the incentive to finance new investments from 

debt rather than equity on account of the deductibility of interest payments on debt but no 

comparable deduction for dividends paid on equity.39 Over-reliance on debt financing can 

increase bankruptcy risk. Finally, there may be incentives created for the retention of earnings in 

the corporation, which may lead to distortions in the allocation of capital to the extent that 

corporations with current earnings have less favorable investment opportunities than would their 

shareholders.40 In addition, present law results in considerable complexity and tax planning as 

taxpayers seek to structure the most tax-favorable form of doing business and providing returns 

to investors. 

At the same time, proposals to eliminate separate corporate and shareholder levels of 

taxation (referred to as “corporate integration”) involve significant policy decisions and can also 

produce considerable complexity. Under present law, although the Code provides rules for 

imposing separate tax at the corporate and at the shareholder level, this does not always result in 

actual payment of two levels of tax. In some cases, the amounts that are distributed to 

 39 Some investors, however, may prefer equity to debt. See discussion of C corporations under 

section II.C. “Choice of Entity”, supra. 

40 The two-tier tax on dividend distributions can make it more desirable for a corporation to use 

retained earnings rather than new equity for its investments. Shareholders can find such earnings 

retention attractive (subject to the accumulated earnings tax and personal holding company rules 

described at footnote 12 supra), if the shareholder expects to defer tax on capital gains for a substantial 

period or to hold stock until death (so that appreciation can be passed to his heirs free of individual 

income tax). 

There also may be an incentive under present law to retain earnings if the corporation's effective 

tax rate on reinvestment is lower than the shareholder tax rate on distributed earnings. By contrast, if the 

shareholder's tax rate is significantly lower than the corporation’s effective tax rate–for example, if the 

shareholder is a tax-exempt entity or is entitled to a corporate dividends-received deduction or to the 

lower rates on dividends to individuals, or if the distribution can be structured as a stock buyback eligible 

for capital gains rates and basis recovery–there may be a tax incentive to distribute earnings or a reduced 

incentive to retain earnings. 
27

shareholders may have borne less than a full tax at the corporate level due to the operation of 

various deductions, deferrals, or other provisions that have reduced or eliminated corporate level 

tax. Also, in some cases, shareholders are tax-exempt, or the rate of tax the shareholder may pay 

is reduced due to capital gains treatment, the lower rates for dividends of individuals, the 

dividends-received deduction for corporations, step-up in basis of stock at death, or other 

provisions. Thus, under present law, the combined individual and corporate tax rates on 

corporate earnings that are distributed to shareholders may not be as great as two full levels of 

tax, and may be less than a single full level of tax. If a decision were made to increase corporate 

integration, policy decisions would need to be made regarding those situations in which at least 

one level of tax should be collected and at which level (corporate or shareholder) it should be 

collected. Complexity would be involved in co-ordinating the tax results at the entity and 

individual levels. 

As one example, consider a corporation whose earnings are subject to little or no tax due 

to tax incentives or preferences for particular types of investment or business activities. Under 

present law, earnings of such a corporation distributed to taxable investors, or gains of such 

investors from retained earnings, may still be taxed to the investors at the “second level” of tax. 

In considering a form of corporate integration, decisions would have be made whether to collect 

at least one full level of tax or whether to pass through the tax benefits to investors. If the latter 

decision is made, issues may still arise regarding the appropriate investors to receive the benefit 

and how to treat situations where shares have changed hands between the time of the tax 

benefited activities and the time of the distribution. Present law rules for partnerships contain 

elaborate rules that attempt to prevent the misallocation of certain tax benefits to partners. 

As another example, consider a corporation that conducts a business activity and that has 

tax-exempt shareholders. Under present law, the income from the business activity is taxed at the 

corporate level although the tax-exempt shareholders are not taxed on dividend income or capital 

gain from their investment. Under present law, the single-level-of-tax regimes do collect a 

business income tax from business activities, even when there are tax-exempt investors. Thus, if 

the tax-exempt corporate shareholders of C corporation conducting a business were instead 

equity owners of a partnership or of an S corporation that conducted the same business, they 

would be subject to unrelated business income tax on their share of partnership or S corporation 

income from such business, whether or not distributed. In considering a form of corporate 

integration, a decision would have to be made whether to continue the present law approach that 

the presence of tax-exempt equity investors does not exempt business income from tax.41 

Foreign investment situations also present issues relating to the adoption and design of an 

integrated system. As one example, under present law, the U.S. collects a corporate level tax on 

U.S. corporate income and a withholding tax on dividend distributions to foreign shareholders.42 

 41 Because present law does not impose tax on interest payments to tax-exempt investors paid by 

partnerships or S corporations engaged in business activity, there is an incentive for tax-exempt investors 

to hold debt rather than equity of business conducted in such pass-through forms under present law. In 

considering approaches to integration, consideration may be given to whether to continue this type of 

difference in the treatment of debt and equity when imposing only a single level of tax. 

42 However, interest paid to foreign shareholders is generally not taxed by the U.S. 
28

Integration proposals that would unilaterally reduce the tax on dividends to foreign investors or 

provide refundable credits for any U.S. corporate tax paid could raise issues if foreign countries 

do not provide similar benefits to U.S investors. 
29

B. Integration Approaches 

A number of methods could be used to achieve full or partial integration, each of which 

has associated policy and administrative considerations.43 

One form, known as “full” integration, involves passing through all items of corporate 

income and deduction to shareholders, including the pass-through of items of a publicly-traded 

corporation. This approach would tax investors currently on their share of corporate income 

even if such income is not distributed to them. Full integration is considered to involve 

administrative difficulties in determining a shareholder’s appropriate share of income, especially 

when stock changes hands during a corporate taxable year. 

Other forms of integration include reduction of the corporate tax on distributed or 

retained corporate earnings, or of the individual tax on distributed earnings or on capital gains 

attributable to undistributed earnings. Complexity can arise, however, if it is desired to design a 

system that will assure the collection of one level of tax, because of the necessity for 

mechanisms that assure that the amounts exempted at either the shareholder or corporate level in 

fact are taxed at the other level. 

The principal approaches to integration usually discussed involve forms of dividend relief 

and thereby apply only to distributed earnings. One approach would give relief by allowing the 

corporation or shareholders to deduct or exclude a portion of dividends. Another approach 

provides a credit to shareholders for taxes paid by the corporation. In 1992, the Treasury 

Department published a report containing a prototype for a form of dividend relief through 

exclusion of previously taxed dividends from shareholder income.44 In 1993, the American Law 

Institute published a proposal involving a credit system based on the model used by a number of 

 43 For a more extensive discussion of the background and issues relating to integration, see 

Michael J. Graetz and Alvin C. Warren, Jr., Integration of the U.S. Corporate and Individual Income 

Taxes (Tax Analysts, 1998); Joint Committee on Taxation, Federal Income Tax Aspects of Corporate 

Financial Structures, JCS-1-89 (January 18, 1989). 

44 U.S. Department of the Treasury, Integration of the Individual and Corporate Tax Systems, 

Taxing Business Income Once (1992). This study also considered alternative integration prototypes. One 

was a “shareholder allocation” prototype that would tax both distributed and retained earnings at the 

shareholder’s tax rate. Another was a “Comprehensive Business Income Tax” prototype that would, in 

effect, extend a dividend exclusion system to payments of interest, and deny interest deductions, in order 

to equalize the treatment of debt and equity; and that would tax corporate and noncorporate businesses in 

the same manner. (See introduction to the study at p.15). This study and a general introduction on 

corporate integration can be found reprinted in Graetz and Warren, op.cit., supra. 
30

other countries.45 Other proposals relating to approaching a single level of tax on business 

income are discussed in the 2005 Report of the President’s Advisory Panel on Tax Reform.46 

In 2003, the President’s budget proposals to the Congress contained a dividend relief 

proposal that attempted to provide relief to shareholders of corporations on dividends attributable 

to previously taxed income of the corporation and also to provide a basis adjustment in a 

shareholder’s stock for undistributed previously taxed income allocated to such stock.47

Subsequently, The Jobs Growth and Tax Relief Act of 2003, following a dividend relief 

approach, temporarily reduced and conformed (but did not eliminate) the tax rates on dividends 

and capital gains, through the end of 2008. The Tax Increase Prevention and Reconciliation Act 

of 2005 extended this rate structure though 2010. 

As noted previously, a determination whether to adopt a particular form of integration 

involves significant policy determinations. Among the policy decisions are whether to pass 

through any corporate business level tax benefits to individual investors; how to treat income 

attributable to tax-exempt investors; how to treat international transactions; and how to treat 

existing corporate equity investments. Some decisions may be more easily implemented if the 

basic form of relief is structured as a dividend exclusion at either the corporate or shareholder 

level. Other issues may be more readily addressed by giving shareholders a credit for their share 

of the corporate tax when they receive dividends. 

In addition, a system imposing only one level of tax would not necessarily be simpler 

than present law. For example, the rules for taxing income of partnerships (which is subject to 

tax only at the partner level) are quite complex. Similarly, those integration approaches that 

provide dividend relief and that also seek to collect at least one level of tax can involve 

complexity. This can result from the need to provide rules that track whether income has borne 

one level of tax when earned at the corporate entity level (or instead has enjoyed tax benefits that 

reduce or eliminate the corporate level tax), and whether the particular type of shareholder to 

which the income is distributed would otherwise generally pay tax on the distribution, absent 

integration relief. 

 45 Alvin C. Warren, Jr., Integration of Individual and Corporate Income Taxes (American Law 

Institute, 1993). This study and a general introduction on corporate integration can be found reprinted in 

Graetz and Warren, op.cit., supra. 

46 The President’s Advisory Panel on Tax Reform; Simple, Fair and Pro-Growth: Proposals to 

Fix American’s Tax System (November 2005), Chapters 7, 8 and 9 (discussing a proposal for a business 

tax reform while retaining some individual tax on investment returns, and also including discussions of 

value added and sales taxes as alternatives to an income tax). 

47 Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2004 

Revenue Proposals, February 2003. 
31

V. MERGERS, ACQUISITIONS, AND RELATED TAX-FREE TRANSACTIONS 

A. Taxable Corporate Transactions 

In general, if a corporate shareholder exchanges a stock investment in one corporation for 

a stock investment in another corporation, the exchange is a taxable event, treated as a sale of the 

transferred stock for the fair market value received and a purchase of the new stock with an 

equivalent cost basis. Also, corporations generally are subject to tax on the disposition of 

appreciated assets (including the disposition of appreciated stock of a subsidiary). Taxable 

dispositions generally include distributions of assets or the stock of a subsidiary to shareholders, 

as well as the disposition of such assets or subsidiary stock to an unrelated acquiror. 

Under present law, corporations and shareholders are taxed separately. There also are 

different tax results depending on whether stock of a corporation is sold and the shareholders 

receive the proceeds, or whether assets of a corporation are sold and the shareholders receive the 

proceeds as a distribution from the corporation. 

If the stock of a corporation is sold, the selling shareholders pay tax on any gain from 

their sale of stock. The acquiror of the corporation holds the acquired stock at its purchase price 

basis, but the basis of assets inside the acquired corporation does not change to reflect the stock 

purchase price unless an election is made to pay “inside” corporate level tax on any gain 

associated with this “inside” asset basis change. Such an election may be made only if 80 

percent of stock48 was acquired by a purchasing corporation, within any 12-month period, in a 

taxable purchase.49 

If the assets of a corporation are sold, the seller pays corporate level tax and the buyer 

obtains a purchase price basis for the assets. If the proceeds of the sale then are distributed to the 

shareholders of the selling corporation, the shareholders generally are subject to shareholder 

level tax on such distribution.50 

 48 The 80-percent stock test refers to 80 percent of the vote and value of the stock of the acquired 

corporation, excluding certain nonvoting preferred stock (the same test that applies for purposes of 

eligibility to file a consolidated return). Sec. 338. 

49 Section 338 provides rules for making the election. If the election is made, the acquired 

corporation pays tax on a deemed sale of its assets, in addition to any tax the shareholders paid on their 

sale of stock. Under a special rule, if the seller corporation was filing a consolidated return with the 

purchased subsidiary (and in certain other circumstances), the seller and purchaser can jointly elect to 

treat the acquisition of subsidiary stock as if it had been an acquisition of the subsidiary’s assets. This 

results in a single level of tax on the seller, measured by the “inside” asset basis of the acquired 

corporation’s assets (rather than by the seller’s stock basis for the acquired corporation’s stock). The 

corporate buyer then holds the acquired subsidiary with a basis for the assets inside the acquired 

subsidiary determined by reference to the purchase price for the stock. Sec. 338(h)(10). 

50 Appreciated corporate assets are generally subject to corporate level tax if they are distributed 

to the shareholders, yielding the same corporate tax result as if the assets had been sold by the corporation 

and the proceeds distributed to the shareholders. Shareholders generally are taxed with reference to the 
32

B. Tax-Free Corporate Transactions 

In general

A number of special provisions enable corporations to combine or separate their 

businesses, and permit the corporate shareholders to shift their investment interests to the 

combined or separated enterprises, without the tax impact that otherwise generally would occur 

on an exchange of appreciated corporate assets for other assets, or of shareholder investment 

interests for other interests. 

Some rules are directed at “acquisitive” transactions, in which one corporation acquires 

the stock or assets of another. Other rules are directed at “divisive” transactions, in which one 

corporation divides its business or subsidiaries into entities separately owned by the corporate 

shareholders. In practice, an acquiror may wish to acquire less than all the assets of a “target” 

corporation, so that there may be preliminary divisions of assets, or separations of subsidiaries, 

to accommodate the needs of a particular transaction. The ease with which such changes can 

occur as part of a transaction and still retain tax-free treatment varies among the different 

provisions. 

Corporate reorganizations

In general

One set of rules establishes several specific types of “corporate reorganizations.”51 Such 

reorganizations include statutory mergers as well as certain transactions in which either 80-

percent stock control,52 or “substantially all” the assets, of one corporation is acquired for voting 

stock of another corporation.53 The “reorganization” rules also address certain combinations and 

divisions of corporations that were under common control,54 transactions that are 

recapitalizations or reincorporations, and bankruptcy restructurings. 

The “corporate reorganization” rules allow tax free treatment in a number of different 

types of situations, provided the proper amount and type of stock consideration is given to the 

shareholders, and provided that a sufficient amount of stock or assets of the target corporation is 

 

fair market value of the assets received in the distribution, and obtain a fair market value basis in such 

assets. 

51 Secs. 354-368. 

52 “Control” for this purpose is defined as 80 percent of the value of all voting stock and 80 

percent of the value of each other class of stock. Sec. 368(c). 

53 The rules also allow certain transactions in which stock of the acquiring corporation’s parent 

corporation is given to former shareholders of the target company in the acquisition, instead of stock of 

the acquiring company itself. 

54 For purposes of this “common control” provision, control is defined as ownership of at least 50 

percent of the vote or value of stock. 
33

acquired. The types of reorganizations often are referred to by reference to the particular 

subsection of Code section 368 (defining such transactions) in which they are described. 

If a transaction qualifies as a “reorganization,” the shareholders generally are not taxed 

on an exchange of stock in one corporation that is a party to the reorganization for stock of 

another corporation that is a party to the reorganization. However, the shareholders are taxed to 

the extent they receive cash, securities in excess of securities surrendered, or other “boot” 

property that may not disqualify the reorganization55 but that is not permitted to be received by 

shareholders without tax to them. Certain “nonqualified preferred stock” is treated as “boot” for 

this purpose.56 Shareholders generally substitute the basis of their stock or securities surrendered 

as their basis for the stock or securities received. However, such basis is reduced for 

nonqualified consideration (not permitted to be received tax-free) and is increased to the extent 

gain was recoginized. 

If a transaction qualifies as a “reorganization,” a corporation that is a party to the 

reorganization also generally is not taxed on its transfers of assets or stock to another party to the 

reorganization. In most cases, assumptions of liabilities of the transferor corporation are not 

treated as taxable consideration to the transferor. Generally, a corporation that is a party to a 

reorganization takes a carryover basis in property received in the reorganization in exchange for 

its own stock or stock of its parent corporation.57 

Most types of reorganizations are subject to a number of “substance over form” rules that 

originated in litigated court cases. A version of these rules has been adopted by the Internal 

Revenue Service (“IRS”) in administrative guidance regarding the circumstances in which the 

IRS will permit a transaction to be characterized as a reorganization without challenge. These 

include a “continuity of shareholder interest”58 rule; a “continuity of business enterprise”59 rule, 

 55 The extent to which property other than stock or securities can be received without also 

disqualifying a transaction from “reorganization’ treatment varies for the different types of 

reorganizations. 

56 This is certain stock that is redeemable within 20 years or that has dividend rights that vary 

with interest rates or other specified indices. Secs. 351(g), 354(a)(2)(C). The Treasury Department has 

authority to issue regulations that could prescribe the treatment of such stock for other purposes. 

57 In certain situations involving the importation of built-in losses, the basis of loss property must 

be reduced to its fair market value. Sec. 362(e)(1). 

58 The Treasury regulations stating the “continuity of shareholder interest” rule generally require 

that a substantial part of the value of the proprietary interests in the target corporation be preserved. Treas. 

Reg. sec. 1.368-1(e). Historically, IRS ruling guidelines provided a “safe-harbor” if stock representing at 

least 50 percent of the value of an acquired corporation is exchanged for stock of the acquiror. Rev. Proc. 

77-37, 1977-2 C.B. 568. More recent regulations adopted in 2005 allow a 40-percent continuity. Treas. 

Reg. sec. 1.368-1(e)(2)(i) and -1(e)(2)(v), examples 1 and 2; T.D. 9225 (September 16, 2005). 

59 The Treasury regulations stating the “continuity of business enterprise “ rule generally require 

a continuation of the target corporation’s historic business, or use of a significant portion of the target 

corporation’s historic business assets in a business. Treas. Reg. sec. 1.368-1(d). 
34

and a “business purpose”60 concept. In spite of the fact that these rules originated as “substance 

over form” concepts, form is extremely important in determining whether a transaction qualifies 

as a reorganization. 

Statutory merger or consolidation (type “A” reorganization)

One basic type of acquisitive reorganization is a statutory merger, or “A” reorganization. 

(sec. 368(a)(1)(A)). This type of reorganization offers relatively flexible rules for structuring a 

transaction. Although such a reorganization is subject to the non-statutory “substance over 

form” concepts described above, there is no specific statutory requirement that a particular 

percentage or type of stock consideration must be given to old “target “ company shareholders, 

or that a particular percentage of the target corporation’s historic business assets must be 

transferred in the reorganization. 

Treasury regulations at one time required that the statutes pursuant to which the merger 

be effected must be those of the United States, a State, the District of Columbia, or a U.S. 

territory. That requirement was recently dropped; so that qualifying transactions can be effected 

under foreign statutes. The regulations do require that the effect of the transaction under the 

statute be an acquisiton of all the assets and liabilities (with certain exceptions) of a combining 

entity and cessation of the separate existence of the combining entities. Thus, in one situation in 

which a new state law defined a divisive transaction as a “merger”, the IRS announced that it 

would not treat such a divisive transaction as a statutory merger for purposes of the 

reorganization rules.61 

Acquisition of corporate stock “control” solely for voting stock (type “B” 

reorganization)

Another type of basic acquisitive reorganization is the acquisition by one corporation of 

stock of another corporation, solely for voting stock either of the acquiror or of its direct parent 

corporation (but not both). Immediately after the acquisition, the acquiror must own 80-percent 

control of the acquired corporation. The presence of any consideration that is not voting stock 

can prevent a transaction from qualifying under this provision. 

Acquisition of “substantially all” the corporate properties “solely for voting stock” 

(type “C” reorganization)

A third type of basic acquisitive reorganization is the acquisition by one corporation of 

substantially all the properties of another corporation, solely for voting stock of the acquiror or 

the direct parent corporation owning 80-percent control of the acquiror. IRS ruling guidelines 

 60 See, e.g., Treas. Reg. secs. 1.368-1(c) and 1.368-2(g); Gregory v. Helvering, 293 U.S. 465 

(1935). 

61 Rev. Rul. 2000-5, 2000-5 I.R.B. 436; Treas. Reg. sec. 1.368-2(b)(1), T.D. 9242 (Jan. 26, 

2006). 
35

define “substantially all the properties” as 90 percent of the net value of assets and 70 percent of 

the gross value of assets.62 

Transfer of substantially all of the assets of a corporation to a related corporation 

(acquisitive type “D” reorganization)63

Another acquisitive type of reorganization is one in which all or a part of a corporation’s 

assets are transferred to another corporation, if immediately after the transfer the transferor or 

one or more of its shareholders own 50 percent of the vote or value of the transferee, and if the 

transferor corporation distributes stock or securities of the corporation to which the assets were 

transferred in a transaction that qualifies under certain other Code provisions (secs. 354, 355, or 

356). In order for the distribution to qualify under section 354, the transferor corporation must 

liquidate and the corporation to which the assets are transferred must acquire substantially all the 

assets of the transferor.64 The consideration need not be all voting stock but can include cash or 

other boot. 

The ownership requirement for this type of reorganization differs from that for other 

acquisitive reorganizations. One purpose of this particular provision is to cause reorganization 

treatment, with accompanying dividend treatment to individual shareholders, if the shareholders 

attempt to liquidate a corporation, take out cash at capital gains rates, and then reincorporate the 

remaining assets.65 

There also is a type of “D” reorganization that is divisive, which also must satisfy the 

“spin-off” rules of section 355 to qualify as tax-free. 

Other “reorganizations”

Other transactions that qualify as reorganizations are a recapitalization (type “E”), a 

“mere change in identity, form, or place of organization” of one corporation (type “F”), and a 

bankruptcy reorganization (type “G”). 

 62 Rev. Proc. 77-37, 1977-2 C.B. 568. 

63 Section 368(a)(1)(D) requires a distribution of the properties received in a transaction that 

qualifies under 354, 355, or 356. Section 355 provides rules for divisive transactions, in which 

substantially all the assets do not need to be transferred. Section 354 provides the rules governing an 

“acquisitive” D reorganization, namely, that substantially all the assets of the transferor must be 

transferred, and the transferor must liquidate. Section 356 provides rules for treatment of consideration 

that is taxable to shareholders, if any is received in addition to stock of the transferee. 

64 Sec. 354(b)(1). 

65 See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the 

Deficit Reduction Act of 1984 (JCS-41-84), December 31, 1984, at 192-194. 
36

Other statutory forms permitted

The Code also contains specific rules allowing: (1) assets of the acquired corporation to 

be directly transferred to the acquiring corporation's controlled subsidiary in exchange for stock 

of the parent (“forward subsidiary merger”)(368(a)(2)(D)); or (2) a subsidiary of the acquiror to 

be merged into the target corporation with the acquired target corporation as the surviving 

corporation (“reverse subsidiary merger”) (368(a)(2)(E)). These special situations can resemble 

the other basic forms of reorganizations such as “statutory mergers” or stock acquisitions, but 

involve some different requirements. 

Definition of “control” for reorganizations

Under the reorganization provisions, the definition of “control” that applies to the 

necessary acquisition of stock and to the determine permitted parent-subsidiary relationships is 

generally 80 percent of the total combined voting power of all classes of stock entitled to vote 

and at least 80 percent of the total number of shares of all other classes of stock of the 

corporation. (sec. 368(c)). 

Transfers to a controlled corporation

Another set of rules governs the general contribution of assets (including stock) to a 

corporation.66 These rules permit the tax-free transfer of assets or stock to a corporation whose 

stock is, in the aggregate, owned at least 80-percent by the transferors who engaged in the 

transfer. The 80-percent control test used here is the same as the control test used for purposes of 

reorganizations, described above. Persons making a transfer generally can receive stock in the 

transferor tax-free, but cash or other “boot” generally is taxed. Certain non-qualified preferred 

stock is treated as “boot” for this purpose.67

Any person who is part of the transferring group can receive qualified stock tax-free, 

without regard to whether the other transferors receive stock, so long as immediately after the 

transfer all the transferors in the aggregate own 80 percent of the transferee. 

The transferee generally takes a carryover basis in the stock or other contributed property 

it receives, and the transferor generally takes a basis in the stock of the transferee corporation 

that is the same as that of the property contributed, decreased by any taxable property received 

and increased by any gain recognized.68

 66 Sec. 351. 

67 This is certain stock that is redeemable within 20 years or that has dividend rights that vary 

with interest rates or other specified indices. Secs. 351(g), 354(a)(2)(C). 

68 In certain cases involving transfers of loss property, either the property must take a fair market 

value basis in the hands of the transferee or the transferor must reduce the basis of its stock in the 

transferee to reflect the fair market value of the contributed property. Sec. 362(e)(2). 
37

Liquidation of corporate subsidiary into parent corporation

Another rule permits the combination of related corporations in the form of a tax-free 

liquidation of an 80-percent owned subsidiary corporation into its parent corporation.69 For 

purposes of the liquidation rule, the definition of 80-percent control is the same as that for 

whether corporations can file a consolidated return.70 

Divisive “spin-off” and similar transactions

In general 

Special rules govern transactions in which one corporation separates its subsidiaries or 

businesses in a divisive “spin-off” or “split up” transaction, in which shareholders of the original 

parent corporation receive stock of one or more corporations that were 80-percent controlled by 

the distributing corporation.71 

The requirements for tax-free treatment under these rules include restrictions that have 

evolved over the years in response to a number of different concerns. 

Anti-“bail out” rules

One set of restrictions for tax-free treatment was intended to prevent a corporation from 

distributing excess liquid assets to shareholders in a form that enabled the shareholders to avoid 

dividend tax. For example, if a corporation distributed excess cash to its shareholders as a 

dividend, they would pay ordinary income tax on the cash they received. However, if the 

corporation could put that cash into a separate corporation and distribute (or “spin off”) the stock 

of that corporation to shareholders, then the shareholders could sell the new stock separately, or 

could liquidate the new corporation, in each case obtaining capital gains treatment on the value 

of the cash received.72

 69 Sec. 332. 

70 “Control” for this purpose is the ownership of 80 percent of the vote and value of stock, 

excluding, however, all nonvoting stock that is limited and preferred as to dividends and that does not 

participate in corporate growth to any significant extent. This definition differs from the definition of 

“control” under the corporate reorganization provisions (sec. 368(c)). 

71 Sec. 355. 

72 See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935), in which the major shareholder, Mrs. 

Gregory, attempted to spin off investment assets through this method. Even before the enactment of 

section 355, the U.S. Supreme Court denied tax-free treatment, stating that the transaction did not have an 

adequate business purpose and was done solely to avoid dividend tax. 

A corporation can distribute excess cash in the form of a redemption of its shareholder’s stock 

that results in capital gains treatment to the shareholders if the transaction results in a meaningful 

reduction of the shareholders’ interests. See sec. 302. 
38

In an attempt to limit such transactions, section 355 requires that both the distributing and 

distributed corporations be engaged in an active business that was not acquired in a taxable 

transaction within five years,73 and that the transaction not be a “device” to distribute earnings 

and profits. Generally, a pre-existing arrangement by a shareholder to sell the stock for capital 

gain would indicate such a device. In addition, common law and IRS rules require that there be a 

corporate business purpose for the distribution. 

Anti-“sale” provisions

The Tax Reform Act of 1986 generally repealed what remained of the so-called General 

Utilities rule that had permitted the sale or disposition of an entire corporate business without 

corporate level tax.74 After the 1986 Act, section 355 remained as a potential method for 

disposing of a subsidiary without corporate level tax. Some such transactions could be 

structured that would provide the acquiror with a fair market value basis in the stock of the 

subsidiary. Other transactions did not necessarily produce a fair market value basis but might 

otherwise be considered “sale-like” in that they involved a plan to dispose of stock to new 

owners in connection with the distribution. 

Several special rules were enacted in an attempt to address such transactions. One 

restriction imposes a corporate level tax if an acquiror obtains control of a distributing 

corporation or its separately distributed subsidiary (but not both) in a divisive transaction where 

the acquiror recently purchased the stock that it controls (sec. 355(d)). Another, later-enacted 

restriction imposes corporate level tax if 50 percent or more of a corporation or its distributed 

subsidiary is acquired by new shareholders as part of a plan related to a spin-off (sec. 355(e)). 

Tax free treatment is also denied to certain distributions involving disqualified 

investment corporations with specified amounts of investment assets (as defined). This rule 

attempts to limit tax-free transactions that may resemble otherwise taxable redemptions or 

distributions with respect to a shareholder’s stock.75

 73 The active business rules allow the distributed and distributing corporate groups to apply the 

active business test aggregating the activities of all members of each such group respectively. Sec. 

355(b)(3). The respective groups are determined using the control test of section 1504, applicable to 

corporations eligible to file consolidated returns, but including foreign and certain other corporations. 

74 See General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935). The actual case 

involved a dividend distribution of stock of a subsidiary to shareholders, followed by a sale of the stock to 

an acquiror. The court upheld the taxpayer’s position that this was not in effect a taxable sale by the 

corporation but was entitled to tax-free treatment on the distribution, under the then existing statute. By 

the time of the 1986 Act, statutory changes had significantly narrowed the cases in which a corporation 

could distribute appreciated stock or assets without corporate level tax. The 1986 Act eliminated the 

statutory provisions that had permitted such a result in an acquisition or liquidation of the entire 

distributing corporation. However, the 1986 Act retained the tax-free spin-off rules of section 355. 

75 Sec. 355(g). 
39

Partnership rules

Partnership rules permit corporations to combine their assets without tax through joint 

venture or other partnership operations, and to separate assets out of partnership structures, often 

also without tax.76 These rules differ from the corresponding rules for transferring assets in and 

out of corporate structures. In general, the partnership rules permit a greater range of tax-free 

transfers than do the corporate rules. However, in some situations the corporate rules might 

more readily permit certain types of transfers. 

 76 Secs. 721-737. 
40

C. Issues Relating to Mergers and Acquisitions 

In general

The different rules permitting particular corporate transactions to receive tax-free 

treatment are varied and frequently inconsistent. In some cases, more than one rule could apply 

to the form of a particular corporate transaction. The statute and the administrative 

pronouncements of the IRS over the years have attempted to resolve overlap situations and to 

provide guidance regarding other interpretive issues. 

The structure of present law is in part a result of the historical development and 

aggregation of provisions. The structure also reflects reactions to judicial decisions interpreting 

particular provisions, and reflects legislative developments establishing new rules and 

accompanying concern that existing provisions, if not limited, might conflict with or undermine 

the new rules. 

The different, and often overlapping, variations within the merger and acquisition rules 

can be viewed as a significant source of complexity. On the other hand, these rules, as they have 

been interpreted and clarified over the years through administrative pronouncements, provide a 

large amount of taxpayer selectivity and certainty. Taxpayers are relatively assured of obtaining 

a specific tax result so long as the transaction satisfies the formalistic requirements of the chosen 

merger and acquisition provision. Moreover, comprehensive reform of these rules and the 

imposition of consistency could not generally be accomplished without recommending 

fundamental changes in the tax policy reflected by one or another of the provisions. 

Discussion of certain proposals

Elective carryover basis for “qualified acquisitions”

An approach that has been suggested by a number of commentators in the past would 

generally permit a corporation to dispose of a business for any type of consideration, including 

cash, and elect to pay no corporate level tax, provided the consideration received is distributed to 

shareholders and that they pay tax (if they are taxable shareholders) on any cash or other 

consideration that is not a qualified continuing stock interest. The acquiring corporation would 

not obtain a stepped-up fair market value basis in the acquired corporate assets if the election 

were made not to pay corporate level tax. Only certain transactions that involved the acquisition 

of a significant amount of the stock of another corporation or the assets of a corporate business 

would qualify for this election. 

Such a proposal was included in a 1985 report prepared by the Staff of the Senate 

Committee on Finance.77 That proposal also included other conforming changes in its attempt to 

substitute a single approach for the present law varied rules affecting tax-free acquisitions. For 

example, the proposal would have conformed the various definitions of “control” under present 

law to the definition for filing a consolidated return. 

 77 The Subchapter C Revision Act of 1985, A Final Report Prepared by the Staff, Committee on 

Finance, United States Senate, S. Prt. 99-47 (May, 1985). 
41

Another version of such a proposal was presented at, and appears in the report of, an 

invitational conference addressing subchapter C issues sponsored by the American Bar 

Association and New York State Bar Association Tax Sections in 1987.78 An earlier proposal of 

this type was made by the American Law Institute.79

This type of proposal involves a specific policy choice to abandon the existing statutory 

requirements for continuity of shareholder interest. The proposal would exempt a corporation 

from tax on a sale of its assets, even if the corporation receives cash consideration for the transfer 

of a business, so long as the cash is distributed to shareholders and the assets transferred retain a 

carryover basis. 

Several policy arguments can be made in favor of such a change. First, as long as assets 

do not obtain a stepped up basis, there is corporate level tax in the future as the recipient 

corporation earns income and retains the low basis assets. Second, as long as shareholders pay 

tax on any cash that is received, this single tax is sufficient as a current tax. Third, the corporate 

reorganization provisions are complex and can be manipulated; and an explicit election would 

simplify corporate tax planning. 

Several policy arguments can also be made against such a change. When assets are 

transferred from one corporation to another for cash, the transferring corporation is generally 

taxed on gain at the time of the transaction or when the cash is received. Payment of tax in the 

future, if the recipient corporation pays more because of a carryover basis, is not the economic 

equivalent of payment of tax at the time of the transaction, but is significantly less due to the 

time value of money. Questions may arise where to draw the line that would allow certain 

transfers of corporate assets, such as a transfer of a “business,” to be exempt from corporate level 

tax while other transfers, such as sales in the ordinary course of business, would not be so 

exempt. Interpretations of the line so drawn would be required. In addition, proposals for such 

restructuring have often involved new sets of rules such as rules regarding the definition of 

control or other issues. New rules could also involve further interpretation and could lead to new 

uncertainty and complexity. 

 78 Ginsburg, Levin, Canellos, and Eustice, “Reexamining Subchapter C: An Overview and some 

Modest Proposals to Stimulate Debate”, (copyright 1987 by Martin D. Ginsburg); reprinted in Corporate 

Tax Reform, A Report of the Invitational Conference on Subchapter C; American Bar Association 

Section of Taxation, New York State Bar Association Tax Section (1988) pp. 39-80; see, e.g., Proposals 

VII-VIIC and IX-XI. 

79 “Proposals on Corporate Acquisitions and Dispositions” adopted by the American Law 

Institute June 13, 1980, published in American Law Institute, Federal Income Tax Project Subchapter C

(1982). 
42

Provide one set of consideration and continuity rules for acquisitive reorganizations

There have been a number of proposals to conform the consideration rules for acquisitive 

reorganizations to require a specified percentage of stock consideration (e.g., 50 percent) and to 

conform the rules as to whether the stock must be voting stock.80 

One policy issue related to such recommendations is the determination what type of stock 

is counted in determining continuity and for purposes of determining whether shareholders are 

taxed. For example, one version of such a proposal suggested that all stock would count (thus 

eliminating a voting stock requirement) but made an exception for certain preferred stock that is 

redeemable within five years. 81

The recommendations are typically made only for the reorganization rules contained in 

section 368. Frequently, no change is recommended to the non-reorganization rules relating to 

transfers to controlled corporations under section 351.82 Under this type of proposal, if the rules 

for non-reorganization transfers to controlled corporations under section 351 are not modified, 

then many of the same planning choices that exist under present law would continue to be 

available. Unless the rules of section 351 are tightened to conform to the new 368 rules in cases 

that resemble acquisitive reorganizations, it is arguable that little general consistency would be 

accomplished.83 On the other hand, such a modification that limited the application of section 

351 could be viewed as a policy decision to tighten the rules relating to acquisitive transactions. 

 80 See, e.g., American Bar Association recommendation 1981-5, 107 ABA Repts. 559, 34 Tax. L. 

1386 (1981). 

81 American Bar Association recommendation 1981-5, supra. 

82 The American Law Institute Proposals that included a provision for elective carryover basis, 

described above, did include a provision overriding section 351 for certain qualified acquisitions. 

However, since the basic proposal for qualified acquisitions abandoned a shareholder continuity of 

interest requirement for qualified acquisitions, the impact of overriding section 351 in those cases was 

confined to a much narrower range of issues. 

83 Partnership rules also could continue to offer different planning approaches to combining 

businesses and assets in some circumstances. 
43

VI. ISSUES RELATED TO CAPITAL COST RECOVERY 

A. In General 

Capital cost recovery raises a number of issues with respect to business taxation. The 

choice of cost recovery rules has an effect on the after-tax rate of return from business assets. 

Policy issues arise as to whether cost recovery rules should be neutral as to a taxpayer’s choice 

whether or in which assets to invest or should be used to encourage investment generally or 

investment in particular kinds of assets. This section describes the concept of cost recovery and 

provides numerical examples to illustrate certain economic and tax effects of various forms of 

cost recovery rules, illustrates how cost recovery can be used to influence investment decisions, 

and summarizes the present law tax rules for cost recovery. 
44

B. Concept of Cost Recovery84

In business taxation, cost recovery refers to the process by which a taxpayer recoups the 

cost of its investment in business or other income-producing property.85 The tax rules permit this 

recoupment through the allowance of deductions for depreciation. In his opinion in the 1927 

U.S. Supreme Court case United States v. Ludey, Justice Brandeis provided the following 

explanation of depreciation: 

The depreciation charge permitted as a deduction from the gross income in 

determining the taxable income of a business for any year represents the 

reduction, during the year, of the capital assets through wear and tear of the plant 

used. The amount of the allowance for depreciation is the sum which should be 

set aside for the taxable year, in order that, at the end of the useful life of the plant 

in the business, the aggregate of the sums set aside will (with the salvage value) 

suffice to provide an amount equal to the original cost. The theory underlying 

this allowance for depreciation is that by using up the plant, a gradual sale is made 

of it. The depreciation charged is the measure of the cost of the part which has 

been sold. When the plant is disposed of after years of use, the thing then sold is 

not the whole thing originally acquired. The amount of the depreciation must be 

deducted from the original cost of the whole in order to determine the cost of that 

disposed of in the final sale of properties.86

The American Institute of Certified Public Accountants (“AICPA”) has provided a 

similar explanation: 

Depreciation accounting is a system of accounting which aims to distribute the 

cost or other basic value of tangible capital assets, less salvage (if any), over the 

estimated useful life of the unit (which may be a group of assets) in a systematic 

and rational manner. It is a process of allocation, not of valuation. Depreciation 

for the year is the portion of the total charge under such a system that is allocated 

to the year.87

 84 Portions of this discussion are drawn from Boris I. Bittker & Lawrence Lokken, Federal 

Taxation of Income, Estates and Gifts (3d. ed. 1999) at ¶23.1. 

85 The tax rules allow cost recovery both for tangible assets and for intangible property such as 

copyrights and patents with limited useful lives. The term “depreciation” sometimes is used only when 

referring to cost recovery for tangible property, while “amortization” is used in describing cost recovery 

for intangible property such as patents and copyrights. Section 167(a), however, which allows a 

depreciation deduction for “the exhaustion, wear and tear (including a reasonable allowance for 

obsolescence) of property used in the trade or business, or of property held for the production of income,” 

encompasses both tangible and intangible property. 

86 274 U.S. 295, 300-301 (1927). 

87 AICPA, Accounting Terminology Bulletin No. 1 (1953). 
45

Both Justice Brandeis’s and the AICPA’s explanations refer to salvage value. Although 

for many years the tax rules required taxpayers to estimate the salvage value of depreciable 

assets and permitted depreciation deductions only to the extent that a taxpayer’s cost basis in an 

asset exceeded the asset’s salvage value, since 1981 the depreciation rules have ignored salvage 

values and a taxpayer is permitted to take deductions for the depreciation of an asset until its 

adjusted basis in the asset has been reduced to zero. 

The Supreme Court and the AICPA explanations differ in their description of the role of 

valuation in determining depreciation allowances. Justice Brandeis writes that a business’s 

depreciation deduction for a year “represents the reduction, during the year, of the capital assets 

through wear and tear.” The AICPA definition, by contrast, states that depreciation accounting 

“is a process of allocation, not of valuation.” The AICPA’s statement is a more accurate 

reflection of the role of valuation in the present tax rules than is Justice Brandeis’s. The amount 

of a depreciation deduction allowed to a taxpayer in any given year for a capital asset generally 

does not reflect the actual reduction in the value of that asset in that year. 

Valuation can be seen, however, as part of the theoretical basis of the depreciation 

allowance. Justice Brandeis writes that the theory of this allowance is that by using up an asset 

over time, a taxpayer makes a “gradual sale” of that asset, and the depreciation deduction in a 

given year measures the cost of the portion of the asset “sold” in that year. This “gradual sale” 

theory reflects the tension between the principles of realization and income measurement. Under 

an ideal income tax, tax liability would be determined in part by changes in the value of a 

taxpayer’s assets even in the absence of a realization event such as a sale of those assets. In fact, 

however, changes in asset value generally do not affect tax liability unless there is a realization 

event. If a depreciation deduction were a proxy for the decline in the value of an asset that a 

taxpayer does not sell, the allowance of the deduction might be seen as moving the tax rules 

toward true income measurement and away from realization. Justice Brandeis rationalized this 

departure from realization through the fiction of a partial sale of an asset each year, with the 

value of the portion fictionally sold represented by the amount of depreciation allowed as a 

deduction. The amount of a depreciation deduction under present law, though, generally does 

not approximate the decline in value of a taxpayer’s assets (or, if it does approximate economic 

depreciation, it does so coincidentally).88 Consequently, in any year, the depreciation allowance 

for a particular asset may cause a taxpayer’s taxable income attributable to that asset to be either 

more or less than the taxpayer’s economic income from the asset. 

The fact that depreciation deductions cause a mismeasurement of economic income from 

an asset when those deductions do not reflect the decline in value of the asset might not, in itself, 

be cause for concern. As described previously, if salvage value is ignored and a taxpayer is 

permitted to recover over time the entire cost of an asset, its depreciation deductions over the life 

of an asset is the same, and its taxable income from the cash flow generated by the asset is the 

same, regardless of the manner in which the taxpayer allocates those deductions over time. As is 

illustrated next, however, the timing of depreciation deductions can vary greatly depending on 

 88 While present-law depreciation deductions do not approximate economic depreciation, assets 

with shorter economic lives generally are assigned shorter recovery periods and assets with longer 

economic lives generally are assigned longer recovery periods under present law. 
46

the particulars of the chosen rules, and timing differences can have a significant effect on the real 

cost of a taxpayer’s tax liability. 
47

C. Examples: Methods of Cost Recovery 

The following examples illustrate the economic and tax effects of several possible 

methods of cost recovery: (1) straight-line depreciation, a method in which a taxpayer’s 

depreciation deduction for a given asset is the same each year; (2) accelerated depreciation, 

under which a taxpayer’s depreciation allowance for an asset is greatest in the first year in which 

the asset is used and declines over time; (3) expensing, in which a taxpayer is permitted to deduct 

the entire cost of an asset in the year in which the taxpayer acquires the asset; and (4) use of a tax 

credit to provide cost recovery or recovery of amounts different from the cost of the asset.89

Each example assumes the following facts. A taxpayer buys a machine for $10,000. The 

machine is used for five years. It generates $3,000 net cash flow annually. It has no salvage 

value. The taxpayer’s tax rate is 35 percent. The discount rate is six percent. The taxpayer is 

assumed to derive other taxable income so that any net decrease in income tax liability (shown in 

each table as a negative number) attributable to the machine can be used to offset the taxpayer’s 

tax liability from its other income sources. The present value (“PV”) figures in the tables are 

derived by assuming that nominal dollars are paid (in the case of taxes) or received (in the case 

of cash flow) at the end of each year and by discounting these nominal dollars back to when the 

machine was purchased, the beginning of year one. Thus, nominal year one dollars paid or 

received are discounted one year in deriving the present value of those dollars, nominal year two 

dollars are discounted two years, and so forth. 

Table 8.−Straight Line Depreciation 

Unrecovered

Cost 

Dollars 

Received 

Cost 

Recovery

Taxable 

Income 

35- 

Percent

Tax 

PV of 

Tax 

Liability 

AfterTax 

Cash 

Flow 

PV of 

After-Tax 

Cash 

Flow 

Year 1 $10,000 $3,000 $2,000 $1,000 $350 $330 $2,650 $2,500 

Year 2 8,000 3,000 2,000 1,000 350 311 2,650 2,358 

Year 3 6,000 3,000 2,000 1,000 350 294 2,650 2,225 

Year 4 4,000 3,000 2,000 1,000 350 277 2,650 2,099 

Year 5 2,000 3,000 2,000 1,000 350 262 2,650 1,980 

End/total $0 $15,000 $10,000 $5,000 $1,750 $1,474 $13,250 $11,162 

 89 These examples provide a comparison of the cash flow and tax effects of the different methods 

of cost recovery. Other issues such as the relative complexity of each method, record-keeping and 

administrability aspects of each method, and the use of methods in combination with each other also 

would have to be taken into account in selecting among cost recovery methods. 
48

Table 9.−Accelerated Depreciation 

Unrecovered

Cost 

Dollars 

Received 

Cost 

Recovery

Taxable 

Income 

35 

Percent

Tax 

PV of 

Tax 

Liability 

AfterTax 

Cash 

Flow 

PV of 

AfterTax 

Cash 

Flow 

Year 1 $10,000 $3,000 $4,000 -$1,000 -$350 -$330 $3,350 $3,160 

Year 2 6,000 3,000 2,400 600 210 187 2,790 2,483 

Year 3 3,600 3,000 1,440 1,560 546 458 2,454 2,060 

Year 4 2,160 3,000 1,080 1,920 672 532 2,328 1,844 

Year 5 1,080 3,000 1,080 1,920 672 502 2,328 1,740 

End/total $0 $15,000 $10,000 $5,000 $1,750 $1,349 $13,250 $11,287 

Table 10.−Expensing 

Unrecovered

Cost 

Dollars 

Received 

Cost 

Recovery

Taxable 

Income 

35 

Percent

Tax 

PV of 

Tax 

Liability 

AfterTax 

Cash 

Flow 

PV of 

AfterTax 

Cash 

Flow 

Year 1 $10,000 $3,000 $10,000 -$7,000 -$2,450 -$2,311 $5,450 $5,142 

Year 2 0 3,000 0 3,000 1,050 934 1,950 1,735 

Year 3 0 3,000 0 3,000 1,050 882 1,950 1,637 

Year 4 0 3,000 0 3,000 1,050 832 1,950 1,545 

Year 5 0 3,000 0 3,000 1,050 785 1,950 1,457 

End/total $0 $15,000 $10,000 $5,000 $1,750 $1,122 $13,250 $11,516 

Economic and tax results

Several observations can be made about these examples. First, in each example, by the 

end of year five, the last year in which the machine is used, the taxpayer has recovered the entire 

cost of the machine, $10,000. Second, measured in nominal or total combined annual dollars, 

the total amount of cash flow ($15,000), income after cost recovery ($5,000), and tax paid 

($1,750) is the same under each of the three methods of depreciation. Third, the amount of the 

taxpayer’s total eventual tax liability expressed in present value terms at the outset of the 

taxpayer’s investment − the number printed at the bottom of the third to last column of each 

example − varies significantly among the three examples. The present value of after-tax cash 

flows likewise varies among the examples. The initial present value of all future tax liabilities 

attributable to the income generated by the machine is greatest under straight-line depreciation, 

somewhat less under accelerated depreciation, and least under expensing. The present value of 
49

after-tax cash flows is the smallest under straight-line depreciation, greater under accelerated 

depreciation, and greater again under expensing. The reason for these relationships is that 

expensing accelerates cost recovery relative to accelerated and straight-line depreciation, and 

accelerated depreciation yields more up-front cost recovery than does straight-line. In the end, 

the entire cost of the machine is recovered under all three methods, but front-loading of 

depreciation deductions and the concomitant lessening of a taxpayer’s tax liability in the early 

years increase the present value of cash flows. 

Tax depreciation compared with economic depreciation

In the examples above, straight-line depreciation is the least favorable method of cost 

recovery for taxpayers. An even less taxpayer-favorable rule might require a taxpayer to wait 

until an asset is used up or sold before recovering any portion of the cost of the asset. The rate of 

cost recovery − straight-line, accelerated, or immediate deduction − is not the only variable that 

affects the present values of taxes and cash flows associated with an asset. The period over 

which costs are recovered also has an effect on these present values. 

To analyze how closely any combination of recovery rates and periods replicates 

economic depreciation, the pattern of an asset’s economic depreciation must be understood. 

Under the assumption that an asset produces level cash flows over its useful life − not always a 

realistic assumption because of the declining efficiency of some assets and, relatedly, because of 

increasing maintenance costs as some assets age − the asset declines in value more slowly in its 

early years than in its later years. 

The value of an asset or, put differently, the amount someone would pay for the asset, at 

any time is the value at that time of all income the asset is expected to generate in the future. An 

asset’s value, in other words, is the present value of its expected future cash flows. The decline 

in value of an asset from the beginning of one year to the end of that year − the asset’s economic 

depreciation − is represented by the difference between the present values of the expected future 

cash flows at the beginning and at the end of the year. 

Assume an asset generates $1,000 in cash flow each year for five years, and assume a 

discount rate of 6 percent. The value at the beginning of year one of the future cash flows 

($1,000 each year for five years) is $4,212; this is the amount a taxpayer would pay for the asset. 

By the end of year one, the value of the future cash flows ($1,000 each year for four years) 

declines to $3,465. In its first year of use, the asset thus has declined in value by $747. The 

pattern of depreciation over the five years is illustrated in the following table: 
50

Table 11.−Economic Depreciation 

Year PV at Beginning PV at End Depreciation 

1 $4,212 $3,465 $747 

2 3,465 2,673 792 

3 2,673 1,833 840 

4 1,833 943 890 

5 943 0 943 

As can be seen in this table, the depreciation in the value of the asset is smallest during 

the first year and increases with each subsequent year. For an asset that generates constant cash 

flows, therefore, tax depreciation rules that matched economic depreciation would backload cost 

recovery to a greater extent than straight-line depreciation rules do. 
51

D. Incentives for Capital Investment 

Expensing

Matching economic depreciation is only one possible goal of cost recovery rules. 

Another possible goal is to provide an incentive for capital investment. Expensing − under 

which, as illustrated previously, a current deduction is allowed for the entire cost of an asset − is 

one way to provide this incentive.90 Under certain assumptions, including that tax rates are the 

same at the beginning and at the end of an investment, allowing a current deduction for the cost 

of an investment is equivalent to exempting from tax the return on the investment. 

A simple example can illustrate this point. Assume a taxpayer earns $1,000 in taxable 

income (in addition to taxable income from other sources) and invests the amount remaining 

after tax is imposed on the $1,000. The asset yields a 10-percent return and is sold after one 

year. The tax rate is 35 percent. In the first scenario, no deduction is allowed for the cost of an 

investment, but the return on the investment is exempt from tax. The taxpayer therefore is taxed 

on the $1,000 when it is earned and is left with $650 ($1,000 - .35($1,000)) to invest. The $650 

investment yields a 10-percent return. After one year, the investment has grown to $715, and 

when the investment is sold, the proceeds are exempt from tax. In the second scenario, the 

taxpayer is allowed a deduction for an investment (that is, the taxpayer is allowed to expense the 

investment) but is taxed when the proceeds from the investment are used for consumption. The 

deduction for the cost of the investment (which can be used as an offset against other taxable 

income) has the effect of eliminating the tax on the $1,000 of earnings, and the taxpayer can 

invest the entire $1,000. After one year, the investment is worth $1,100. The taxpayer sells the 

investment (and does not use the proceeds for a deductible investment). The $1,100 in proceeds 

therefore is subject to a 35-percent tax, and the taxpayer is left with $715 ($1,100 - .35($1,100)) 

after tax. The taxpayer is in the same position as where no deduction was allowed for the initial 

investment but the return on the investment was free of tax. 

Investment tax credit

Expensing is one way of providing an incentive for capital investment. Another method 

is through the use of tax credits. For much of the period from 1962 through 1985, the tax rules 

included an investment tax credit for the purchase of tangible property and certain other kinds of 

property for use in a business or profit-seeking activity. The credit amount initially was seven 

percent of the cost of the property and was increased to 10 percent.91 The following table shows 

the effects of a five-percent income tax credit under the assumptions used in Tables 1 through 3: 

A machine with a five-year life is purchased for $10,000, the machine generates annual cash 

flow (net of expenses) of $3,000, and the discount rate is six percent. As is shown in the table, 

the five-percent investment credit generates a $500 tax savings (five percent of $10,000) in year 

one and requires the taxpayer to reduce its basis in the machine by $500 in that year (from 

 90 Any method of cost recovery that is faster than economic depreciation provides a tax incentive 

for investment in the property for which the recovery method is available. 

91 See Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts (3d. 

ed. 1999) at ¶27.2.1. 
52

$10,000 to $9,500). The table assumes the taxpayer then is required to use straight-line 

depreciation in recovering its remaining cost. 

Table 12.−Investment Tax Credit 

Unrecovered 

Cost 

Dollars 

Received 

Cost 

Recovery 

Taxable 

Income 

35 

Percent

Tax 

PV of 

Tax 

Liability 

AfterTax 

Cash 

Flow 

PV of 

AfterTax 

Cash 

Flow 

Year 1 $9,500* $3,000 $1,900 $1,100 -$115** -$108 $3,115 $2,939

Year 2 7,600 3,000 1,900 1,100 385 343 2,615 2,327

Year 3 5,700 3,000 1,900 1,100 385 323 2,615 2,196

Year 4 3,800 3,000 1,900 1,100 385 305 2,615 2,071

Year 5 1,900 3,000 1,900 1,100 385 288 2,615 1,954

End/total $0 $15,000 $9,500*** $5,500 $1,425 $1,151 $13,575 $11,487

* After initial basis reduction for 5-percent investment credit equaling $500. 

** Including $500 investment credit. 

*** Not including $500 initial basis reduction from investment tax credit. 

Table 12 reveals that under the assumptions of the depreciation examples discussed 

above, the combination of the investment tax credit and straight-line depreciation produces a 

greater present value after-tax cash flow than does accelerated depreciation in the absence of the 

investment credit, and it produces slightly less present value after-tax cash flow than does 

expensing. More broadly, however, through the choice of, among other features, a credit rate, an 

investment credit can be designed to replicate the economic and tax results of a given set of 

depreciation rules. 

The most favorable cost recovery method described above, expensing, can, as discussed 

previously, have the same after-tax effects as would exempting from tax the return on an 

investment. Certain rules (including investment credits) can produce a result better than 

exemption. From 1981 until 1986, “the tax benefits of the combination of the investment tax 

credit and accelerated depreciation were more generous for some equipment than if the full cost 

of the investment were deducted immediately − a result more generous than exempting all 

earnings on the investment from taxation.”92 This result had the effect of encouraging 

investment in equipment qualifying for generous treatment even if the investment would have 

been unprofitable in the absence of the tax rules. 

 92 Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-

87), May 4, 1987, p. 98. 
53

E. Present-Law Cost Recovery Tax Rules 

In general

The present-law cost recovery rules are not as simple as any of the stylized approaches 

described above (though the pattern of cost recovery in the accelerated depreciation example 

matches the pattern of cost recovery under one permitted method of depreciation described 

below), but they do include features of some of the approaches. The cost recovery rules do not 

match tax depreciation with economic depreciation. In most circumstances, the rules permit 

accelerated depreciation, and in some cases require (or permit) straight-line depreciation. In 

some cases the rules permit limited expensing. Furthermore, the benefit of tax depreciation 

deductions in excess of economic depreciation may be augmented by use of a tax-deferred 

transaction such as like-kind exchange. 

Depreciation provisions

A taxpayer is allowed to recover through annual depreciation deductions the cost of 

certain property used in a trade or business or for the production of income. The amount of the 

depreciation deduction allowed with respect to tangible property for a taxable year is determined 

under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different 

types of property are generally assigned applicable recovery periods and depreciation methods. 

The recovery periods applicable to most tangible personal property (generally tangible property 

other than residential rental property and nonresidential real property) range from three to 25 

years. The depreciation methods generally applicable to tangible personal property are, as the 

MACRS name suggests, forms of accelerated depreciation. The permitted methods are the 200-

percent and 150-percent declining balance methods, switching to the straight-line method for the 

taxable year in which the depreciation deduction would be maximized.93

Recovery periods for real property generally are longer than those for personal property, 

and the depreciation method is less favorable to taxpayers. In general, the recovery periods 

applicable to real property are 39 years for non-residential real property and 27.5 years for 

residential rental property. The depreciation method for real property is the straight-line method. 

Under MACRS, a taxpayer is permitted to recover its full basis in depreciable property 

over the applicable recovery period; there is no need to estimate salvage value. Moreover, under 

MACRS the applicable recovery period need not (and typically does not) correspond to the 

actual economic life of the asset subject to depreciation. In general, however, MACRS generally 

provides for longer recovery periods for longer lived assets. 

 93 For certain property, including tangible property used predominantly outside the United States, 

tax-exempt use property, tax-exempt bond-financed property, and certain other property, the MACRS 

“alternative depreciation system” of section 168(g) applies, generally increasing recovery periods and 

requiring straight-line depreciation. 
54

Expensing provisions

Since 1958, the Code has permitted limited expensing. Under present-law section 179, a 

taxpayer with a sufficiently small amount of annual investment costs may elect to deduct at least 

a portion of those costs currently. For taxable years beginning in 2003 through 2009, the 

maximum amount a taxpayer may expense is $100,000 of the cost of qualifying property placed 

in service for the taxable year.94 In general, qualifying property is defined as depreciable 

tangible personal property that is purchased for use in the active conduct of a trade or business. 

The $100,000 amount is reduced (but not below zero) by the amount by which the cost of 

qualifying property placed in service during the taxable year exceeds $400,000. The $100,000 

and $400,000 amounts are indexed for inflation.95 Certain additional rules govern section 179 

computations and eligibility and the coordination of section 179 with other rules.96

 94 Additional section 179 incentives are provided for qualified property used by a business in the 

New York Liberty Zone (sec. 1400L(f)), an empowerment zone (sec. 1397A), a renewal community (sec. 

1400J), or the Gulf Opportunity Zone (sec. 1400N(e)). 

95 For taxable years beginning in 2010 and thereafter, a taxpayer with a sufficiently small amount 

of annual investment may elect to deduct up to $25,000 of the cost of qualifying property placed in 

service for the taxable year. The $25,000 amount is reduced (but not below zero) by the amount by which 

the cost of qualifying property placed in service during the taxable year exceeds $200,000. 

96 The amount eligible to be expensed for a taxable year may not exceed the taxable income 

derived in that year from the active conduct of a trade or business (determined without regard to section 

179). Any amount that is not allowed as a deduction because of the taxable income limitation may be 

carried forward to succeeding taxable years (subject to similar limitations). No general business credit 

under section 38 is allowed with respect to any amount for which a deduction is allowed under section 

179. An expensing election is made under certain rules prescribed by the Secretary. 
55

VII. INTERNATIONAL TAX ISSUES 

A. In General 

A country’s tax system can generally be classified as either “worldwide” or “territorial” 

based upon how such system treats income earned by taxpayers from sources outside of the 

taxing jurisdiction. The United States currently employs a predominantly worldwide tax system. 

Worldwide tax system 

In a pure worldwide tax system, resident individuals and entities are taxable on their 

worldwide income, regardless of where the income is derived. Double taxation of foreign 

income is mitigated through the allowance of a foreign tax credit. Proponents of a worldwide tax 

system argue that it promotes economic efficiency, because it does not distort the decision of 

whether to locate investment at home or abroad. A resident has no tax incentive under a 

worldwide system either to move activities abroad or to keep them within the taxpayer’s country 

of legal residence (the “residence country”) − in either case the income generally is subject to tax 

at the residence-country rate. Thus, investment-location decisions are governed by business 

considerations, instead of by tax law. This efficiency norm is referred to as “capital export 

neutrality.” 97 

Common deviations from the “pure” form of the worldwide tax system, such as the 

foreign tax credit limitation and deferral, reduce this neutrality. For example, although a pure 

worldwide tax system would allow the unlimited use of foreign tax credits to offset all 

worldwide income (including “domestic” income, i.e., income earned from sources within the 

residence country), in practice the credit is generally limited to ensure that the residence country 

preserves its right to tax income derived within the residence country. Also, because 

corporations are generally respected as separate entities, foreign-source income earned by a 

resident through a foreign corporation generally is not subject to tax until repatriated. This 

mechanism is known as “deferral.”98 In the United States, complex anti-deferral regimes apply 

as exceptions to this general rule and tax U.S. shareholders currently on certain mobile or passive 

income derived through certain foreign corporations. 

A worldwide tax system arguably preserves the residence-country tax base more 

effectively than a pure territorial system. If foreign-source income is entirely exempt from 

taxation, then resident taxpayers will have an incentive to shift investment and income into 

lower-tax jurisdictions, thus eroding the residence-country tax base. For this reason, even those 

countries that employ predominantly territorial systems (e.g., France) typically provide for 

 97 However, as discussed below, proponents of a territorial system argue that it better promotes a 

different form of neutrality. 

98 By contrast, a pure worldwide tax system would generally not offer deferral. Instead, income 

earned by wholly-owned foreign corporations would be subject to current taxation in the parent 

corporation’s residence country; as in the case of a “classic” worldwide system, double taxation would be 

mitigated through the allowance of a foreign tax credit. 
56

current taxation of certain types of foreign-source income that may easily be earned in tax 

havens − a significant departure from “pure” territorial taxation.99

Territorial tax system

In a pure territorial tax system, the country taxes only income derived within its borders, 

irrespective of the residence of the taxpayer. Thus, unlike in a worldwide tax system, foreignsource income earned by a resident is exempt from residence-country tax. There is no need for a 

foreign tax credit, because exemption generally eliminates the possibility of double taxation of 

foreign income. There also is no need for complicated anti-deferral rules, because foreignsource income is exempt from tax in the first place. As a practical matter, however, countries 

that have adopted territorial-type tax systems generally have included exceptions to the principle 

of territoriality for certain cases deemed to be abusive, using mechanisms similar to the U.S. 

anti-deferral rules and foreign tax credit. 

Proponents of a territorial system argue that it promotes economic efficiency, because a 

territorial system treats all investment within a particular country (the “source country”) the 

same, regardless of the residence of the investor. This efficiency norm is referred to as “capital 

import neutrality.” Thus, if a residence country adopts a pure territorial system, residents of that 

country, when investing abroad in a particular source country, do not bear any greater tax burden 

(by virtue of their country of residence) than similarly situated investors residing either in that 

source country or in another country with a territorial tax system. For example, if a source 

country provides low effective tax rates on manufacturing income, a taxpayer resident in a 

country with a territorial tax system will fully enjoy the benefits of the lower source-country rate, 

while a taxpayer resident in a country with a worldwide tax system generally will not. In a world 

with diverse tax systems and rates, it is generally impossible to fully achieve both capital import 

neutrality and capital export neutrality at the same time. Thus, difficult balancing decisions are 

unavoidable, and there is no consensus as to which of the two goals should take precedence. 

Mixed systems 

No country uses a pure worldwide or territorial system. Systems may be accurately 

characterized as predominantly worldwide or territorial, but all systems currently in use share at 

least some features of both worldwide and territorial approaches. 

 99 Likewise, both worldwide and territorial tax systems may employ various rules to limit the 

improper shifting of income from high-tax to low-tax countries (such as transfer pricing and expense 

allocation rules). 
57

B. The U.S. International Tax System 

1. Tax treatment of foreign activities of U.S. persons 

In general

Under the current United States tax system, domestic corporations100 generally are taxed 

on all income, whether derived in the United States or abroad. Income earned by a domestic 

parent corporation from foreign operations conducted by foreign corporate subsidiaries generally 

is subject to U.S. tax when the income is distributed as a dividend to the domestic parent 

corporation. Until that repatriation, the U.S. tax on the income generally is deferred. However, 

certain anti-deferral regimes may cause the domestic parent corporation to be taxed on a current 

basis in the United States on certain categories of passive or highly mobile income earned by its 

foreign corporate subsidiaries, regardless of whether the income has been distributed as a 

dividend to the domestic parent corporation. The main anti-deferral regimes in this context are 

the controlled foreign corporation rules of subpart F101 and the passive foreign investment 

company rules.102 A foreign tax credit generally is available to offset, in whole or in part, the 

U.S. tax owed on foreign-source income, whether the income is earned directly by the domestic 

corporation, repatriated as an actual dividend, or included in the domestic parent corporation’s 

income under one of the anti-deferral regimes.103

Foreign tax credit

The United States generally provides a credit for foreign income taxes paid or accrued.104 

In the case of foreign income taxes paid or accrued by a foreign subsidiary, a U.S. parent 

corporation is generally entitled to an indirect (also referred to as a deemed paid) credit for those 

taxes when it receives an actual or deemed distribution of the underlying earnings from the 

foreign subsidiary.105 The foreign tax credit generally is limited to the U.S. tax liability on a 

taxpayer’s foreign-source income. This limit is intended to ensure that the credit serves its 

purpose of mitigating double taxation of foreign-source income without offsetting the U.S. tax 

on U.S.-source income.106 

 100 A domestic corporation is generally any corporation created or organized in the United States 

or under the law of the United States or of any state (or the District of Columbia). Sec. 7701(a)(4). Some 

other countries determine the residency of a corporation by looking to the predominant location of the 

corporation’s management and control, regardless of the country of legal incorporation. 

101 Secs. 951-964. 

102 Secs. 1291-1298. 

103 Secs. 901, 902, 960, 1291(g). 

104 Sec. 901. 

105 Secs. 902, 960. 

106 Secs. 901, 904. 
58

To determine the amount of allowable foreign tax credits after taking into account the 

foreign tax credit limitation, a taxpayer must allocate gross income and expenses between U.S. 

and foreign sources. Under present law, interest expense that a U.S.-based multinational 

corporate group incurs in the United States is allocated between U.S. and foreign sources based 

on the gross assets located in the United States relative to those located abroad (measured either 

by basis or by fair market value).107 Thus, a U.S.-based multinational with a significant portion 

of its assets overseas must allocate a significant portion of its U.S. interest expense to foreignsource income. This allocation has the effect of reducing the foreign tax credit limitation and 

thus reducing the credits allowable (even though the interest expense incurred in the United 

States is generally not deductible in computing the actual tax liability under applicable foreign 

law).108 

To reduce the extent to which excess foreign taxes paid in a high-tax foreign jurisdiction 

can be applied to offset the residual U.S. tax (or “cross-credited”) on low-taxed foreign-source 

income, the foreign tax credit limitation is applied separately to different types of foreign-source 

income. This sort of cross-crediting is constrained by rules that require the computation of the 

foreign tax credit limitation on a category-by-category basis.109 For taxable years beginning 

prior to January 1, 2007, section 904(d) provides eight separate baskets as a general matter, and 

effectively many more in situations in which various special rules apply.110 

Special rules govern the ability of a taxpayer with excess foreign tax credits (that is, an 

amount of foreign tax credits which exceeds the foreign tax credit limitation for the taxable year) 

to offset such excess credits against tax liability arising in a prior year (credits so utilized are said 

to be carried back) or in a subsequent year (carried forward).111 In general, excess credits 

generated in a taxable year are permitted to be carried back to the immediately preceding taxable 

year and carried forward ten taxable years (in chronological order), and are usable only as a 

 107 Sec. 864(e); Temp. Reg. sec. 1.861-11T. 

108 The American Jobs Creation Act of 2004 (“AJCA”), Pub. L. No. 108-357, made certain 

changes to the interest expense allocation rules, effective for taxable years beginning after December 31, 

2008, intended to mitigate this effect. AJCA sec. 401. 

109 Sec. 904(d). To illustrate, suppose a taxpayer pays foreign tax at an effective rate of 45 

percent on certain active income earned in a high-tax jurisdiction, and pays little or no foreign tax on 

certain passive income earned in a low-tax jurisdiction. In the absence of the separate limitation rules, 

earning untaxed (or low-taxed) passive income could permit the taxpayer to claim a credit for the 

otherwise uncreditable excess foreign taxes paid to the high-tax jurisdiction by increasing the foreign tax 

credit limitation without increasing the amount of foreign taxes paid. The separate limitation rules are 

intended to prevent this cross-crediting by placing the passive income and the active income into separate 

limitation categories (or “baskets”), so that the low-taxed passive income does not increase the foreign tax 

credit limitation applicable to the credits arising from the high-taxed active income. 

110 AJCA reduced the number of baskets from nine to eight (eliminating the 10/50 basket) for 

taxable years beginning after December 31, 2002, and further reduced the number of baskets to two for 

taxable years beginning after December 31, 2006. AJCA sec. 404. 

111 Sec. 904(c). 
59

credit (not as a deduction), and only to the extent that there is excess foreign tax credit limitation 

in the carryover or carryback year.112 If credits cannot be utilized within the one-year carryback 

and ten-year carryforward period, they expire and are permanently disallowed. 

Anti-deferral regimes

In general

Generally, income earned indirectly by a domestic corporation through a foreign 

subsidiary corporation is subject to U.S. tax only when the income is distributed to the domestic 

parent corporation because corporations generally are treated as separate taxable persons for 

Federal tax purposes. However, this deferral of U.S. tax is limited by anti-deferral regimes that 

impose current U.S. tax on certain types of income earned by certain corporations. These antideferral rules are intended to prevent taxpayers from avoiding U.S. tax by shifting passive or 

other highly mobile income into low-tax jurisdictions. Deferral of U.S. tax is permitted, on the 

other hand, for most types of active business income earned abroad. 

Subpart F

Subpart F,113 applicable to controlled foreign corporations and their shareholders, is the 

main anti-deferral regime of relevance to a U.S.-based multinational corporate group. A 

controlled foreign corporation generally is defined as any foreign corporation if U.S. persons 

own (directly, indirectly, or constructively) more than 50 percent of the corporation’s stock 

(measured by vote or value), taking into account only those U.S. persons that own at least 10 

percent of the stock (measured by vote only).114 Under the subpart F rules, the United States 

generally taxes the U.S. 10-percent shareholders of a controlled foreign corporation currently on 

their pro rata shares of certain income of the controlled foreign corporation (referred to as 

“subpart F income”), without regard to whether the income is distributed to the shareholders.115 

In effect, the United States treats the U.S. 10-percent shareholders of a controlled foreign 

corporation as having received a current distribution out of the corporation’s subpart F income. 

Subpart F income generally includes passive income and other income that is readily 

movable from one taxing jurisdiction to another. Subpart F income consists of foreign base 

company income,116 insurance income,117 and certain income relating to international boycotts 

 112 In addition, excess credits are carried forward or carried back on a separate limitation basis. 

Thus, if a taxpayer has excess foreign tax credits in one basket for a taxable year, those excess credits 

may be carried back and forward only as taxes allocable to that basket, notwithstanding the fact that the 

taxpayer may have excess foreign tax credit limitation in another basket for that year. 

113 Secs. 951-964. 

114 Secs. 951(b), 957, 958. 

115 Sec. 951(a). 

116 Sec. 954. 

117 Sec. 953. 
60

and other violations of public policy.118 Foreign base company income consists of foreign 

personal holding company income, which includes passive income such as dividends, interest, 

rents, and royalties, and a number of categories of income from business operations, including 

foreign base company sales income, foreign base company services income, and foreign base 

company oil-related income.119 

The U.S. 10-percent shareholders of a controlled foreign corporation also are required to 

include currently in income for U.S. tax purposes their pro rata shares of the corporation’s 

earnings invested in certain items of U.S. property.120 This U.S. property generally includes 

tangible property located in the United States, stock of a U.S. corporation, an obligation of a U.S. 

person, and certain intangible assets, such as patents and copyrights, acquired or developed by 

the controlled foreign corporation for use in the United States.121 There are specific exceptions 

to the general definition of U.S. property, including for bank deposits, certain export property, 

and certain trade or business obligations.122

Exceptions to Subpart F

As described above, one category of subpart F income is foreign personal holding 

company income. This category includes passive income such as dividends, interest, rents, and 

royalties. Foreign personal holding income generally does not, however, include dividends and 

interest received by a CFC from a related corporation organized and operating in the same 

foreign country in which the CFC is organized. It also generally does not include rents and 

royalties received by a CFC from a related corporation for the use of property within the country 

in which the CFC is organized. The recently-enacted Tax Increase Prevention and 

Reconciliation Act of 2005 (“TIPRA”)123 added a new exclusion from foreign personal holding 

company income for dividends, interest, rents, and royalties received by one CFC from a related 

CFC (with relation based on control) to the extent attributable or properly allocable to nonsubpart-F income of the payor.124 The exclusion applies for taxable years beginning after 2005 

and before 2009. 

Under a provision enacted in 1997 and originally applicable only for one taxable year,125

there is an exclusion from subpart F income for certain income of a controlled foreign 

 118 Sec. 952(a)(3)-(5). 

119 Sec. 954. AJCA eliminated the category of foreign base company shipping income. 

120 Secs. 951(a)(1)(B), 956. 

121 Sec. 956(c)(1). 

122 Sec. 956(c)(2). 

123 Pub. L. No. 109-222 (2006). 

124 TIPRA sec. 103(b). 

125 Pub. L. No. 105-34, sec. 1175. 
61

corporation that is derived in the active conduct of a banking or financing business (“active 

financing income”).126 Congress has extended the application of section 954(h) several times, 

most recently in TIPRA.127 The exception from subpart F for active financing income now 

applies to taxable years of foreign corporations starting before January 1, 2009 (and to taxable 

years of U.S. shareholders with or within which those corporate taxable years end).128 A similar 

provision excludes from subpart F income certain income of a controlled foreign corporation that 

is derived in the active conduct of an insurance business.129

Passive foreign investment companies

The Tax Reform Act of 1986 established an anti-deferral regime for passive foreign 

investment companies. A passive foreign investment company generally is defined as any 

foreign corporation if 75 percent or more of its gross income for the taxable year consists of 

passive income, or 50 percent or more of its assets consists of assets that produce, or are held for 

the production of, passive income.130 Alternative sets of income inclusion rules apply to U.S. 

persons that are shareholders in a passive foreign investment company, regardless of their 

percentage ownership in the company, each designed to ensure that U.S. shareholders do not 

improperly benefit from the deferral of tax on the income of the passive foreign investment 

company. 

Temporary dividends received deduction for repatriated foreign earnings

Section 421 of AJCA added to the Code section 965, a temporary provision intended to 

encourage the repatriation of certain low-taxed foreign earnings. As discussed above, the U.S. 

tax rules generally allow a U.S. corporation to defer U.S. income tax on the active foreign-source 

income earned abroad by its CFCs until such income is returned to the United States. By 

providing a present-value benefit to U.S. taxpayers who keep low-taxed CFC earnings offshore, 

these rules operate as a disincentive to repatriate such earnings. In addition, U.S. generally 

accepted accounting principles (“U.S. GAAP”) may provide a further (and related) disincentive 

for publicly traded companies to repatriate low-taxed CFC earnings.131

 126 Sec. 954(h). 

127 TIPRA sec. 103(a)(2); Pub. L. No. 107-147, sec. 614 (2002); Pub. L. No. 106-170, sec. 503 

(1999); Pub. L. No. 105-277 (1998). 

128 TIPRA sec. 103(a)(2); Code sec. 954(h)(9). 

129 Sec. 954(i). 

130 Sec. 1297. 

131 In particular, Accounting Principles Board Opinion 23 (“APB 23”) provides an exception to 

the general rule of comprehensive recognition of deferred taxes for temporary book-tax differences. (For 

a general overview of the financial accounting rules relating to book-tax differences, see Joint Committee 

on Taxation, Present Law and Background Relating to Corporate Tax Reform: Issues of Conforming 

Book and Tax Income and Capital Cost Recovery (JCX-16-06), May 8, 2006.) The exception applies to 

temporary differences related to undistributed earnings of foreign subsidiaries and foreign corporate joint 
62

Under section 965, certain dividends received by a U.S. corporation from its controlled 

foreign corporations were eligible for an 85-percent dividends-received deduction.132 The 

deduction is subject to a number of general limitations.133 Under section 965(d), no foreign tax 

credit (or deduction) is allowed for foreign taxes attributable to the deductible portion of any 

dividend.134 In addition, deductions are disallowed for expenses that are directly allocable to the 

deductible portion of any dividend. 

In enacting section 421 of AJCA, the Congress emphasized that this tax reduction is a 

temporary economic stimulus measure, and that there is no intent to make the measure 

permanent, or to “extend” or enact it again in the future.135

2. Tax treatment of U.S. activities of foreign persons 

The United States asserts taxing jurisdiction over nonresident alien individuals and 

foreign corporations (“foreign persons”) only with respect to income that has a sufficient nexus 

to the United States. Foreign persons are subject to net-basis U.S. tax on income that is 

 

ventures that meet the indefinite reversal criterion in APB 23 (such earnings are said to be “permanently 

reinvested”). Under U.S. GAAP, a U.S. multinational company generally includes the pre-tax income of 

its CFCs in the U.S. parent’s consolidated financial statements (thereby increasing its reported earnings to 

reflect the foreign income of its CFCs); however, if the APB 23 exception applies, the company is not 

required to make an accrual for the residual U.S. tax that will be imposed when the earnings are 

repatriated (thereby avoiding a reduction of its reported earnings to take into account the U.S. tax liability 

which would be due upon repatriation). The rationale for this exception is that, when management of the 

company asserts that certain low-taxed foreign earnings will never be repatriated, it would be inconsistent 

with the objectives of U.S. GAAP (including the objective of providing investors with accurate 

information) to require a current accrual for future U.S. taxes that management, according to such 

assertion, expects that the company will never be required to pay. Instead, under APB 23, the company 

reduces its reported consolidated income to reflect the residual U.S. tax on the CFC’s earnings only at the 

time such earnings are repatriated (or when such earnings no longer qualify as “permanently reinvested,” 

if earlier). Thus, just as taxpayers can often defer the cash payment of U.S. tax until foreign income is 

repatriated, so too publicly-traded U.S. multinational companies can often avoid reporting this tax 

expense in their public financial statements until the foreign income is repatriated. 

132 At the taxpayer’s election, this deduction was available for dividends received either during 

the taxpayer’s first taxable year beginning on or after October 22, 2004, or during the taxpayer’s last 

taxable year beginning before such date. 

133 First, it applied only to cash repatriations generally in excess of the taxpayer’s average 

repatriation level calculated for recent taxable years. Second, the amount of dividends eligible for the 

deduction was generally limited to the amount of earnings shown as permanently invested outside the 

United States on the taxpayer’s recent audited financial statements.133 Third, in order to qualify for the 

deduction, dividends must have been described in a domestic reinvestment plan approved by the 

taxpayer’s senior management and board of directors. 

134 Section 965 did not provide for any specific adjustment to the foreign tax credit limitation of a 

taxpayer that paid qualifying dividends, as the deduction itself had the effect of appropriately reducing the 

taxpayer’s limitation. 

135 H.R. Rep. No. 108-548, at 43 (2004); S. Rep. No. 108-192, at 50 (2003). 
63

“effectively connected” with the conduct of a trade or business in the United States. Effectively 

connected income generally is taxed in the same manner and at the same rates as the income of a 

U.S. person.136

Foreign persons are also subject to a gross-basis U.S. tax at a 30-percent rate on certain 

categories of non-effectively-connected income derived from U.S. sources (interest, dividends, 

rents, royalties, and other similar types of income), subject to a few exceptions.137 One major 

exception is that certain types of interest (for example, interest from certain bank deposits and 

from certain portfolio obligations) are not subject to the tax.138 The tax generally is collected by 

means of withholding by the person making the payment to the foreign person receiving the 

income.139

The Code includes certain rules, known as “thin capitalization” rules, intended to prevent 

foreign corporations from eliminating or inappropriately reducing the income of their U.S. 

subsidiaries through excessive interest deductions. Those rules provide, in part, that the interest 

paid or accrued by a domestic corporation is nondeductible if it is paid or accrued to a related 

party, no tax is imposed on the payment, and the domestic corporation has a debt-equity ratio 

exceeding 1.5 to one. The amount that is nondeductible generally is limited to the excess of the 

domestic corporation’s net interest expense − that is, interest expense less interest income − over 

its taxable income (with certain adjustments).140

3. Transfer pricing 

Due to the variation in tax rates and tax systems among countries, a multinational 

enterprise, whether U.S.-based or foreign-based, may have an incentive to shift income, 

deductions, or tax credits among commonly controlled entities in order to arrive at a reduced 

overall tax burden. Such a shifting of items between commonly controlled entities could be 

accomplished by establishing artificial, non-arm’s-length (i.e., non-market) prices for 

transactions between group members. 

Under section 482, the Secretary of the Treasury is authorized to redetermine the income 

of an entity subject to U.S. taxation when necessary to prevent an improper shifting of income 

between that entity and a commonly controlled entity. The statute generally does not prescribe 

any specific reallocation rules that must be followed; it establishes the general standards of 

preventing tax evasion and clearly reflecting income. Treasury regulations adopt the concept of 

 136 Secs. 871(b) and 882. 

137 Secs. 871 and 881. As discussed in section VII.B.4, below, tax treaties frequently reduce this 

rate of tax for payments made to residents of treaty partners. 

138 Secs. 871(h)-(i), 881(c)-(d). 

139 Secs. 1441, 1442. 

140 Sec. 163(j). 
64

an arm’s length standard as the method for determining whether reallocations are appropriate.141 

Thus, the regulations generally attempt to identify the respective amounts of taxable income of 

the related parties that would have resulted if the parties had been uncontrolled parties dealing at 

arm’s length. 

4. Treaties 

In addition to the U.S. and foreign statutory rules for the taxation of foreign income of 

U.S. persons and U.S. income of foreign persons, bilateral income tax treaties limit the amount 

of income tax that may be imposed by one treaty partner on residents of the other treaty partner. 

For example, treaties often reduce or eliminate withholding taxes imposed by a treaty country on 

certain types of income, such as dividends, interest and royalties, paid to residents of the other 

treaty country.142 For another example, treaties set the standard for the taxation by a treaty 

country of the business activities of a resident of the other treaty country (known as a “permanent 

establishment”). Treaties also include provisions governing the creditability of taxes imposed by 

the treaty country in which income is earned in computing the amount of tax owed to the other 

country by its residents with respect to that income. Treaties further provide procedures under 

which inconsistent positions taken by the treaty countries on a single item of income or 

deduction may be mutually resolved by the two countries. 

The United States has a network of 58 bilateral income tax treaties covering 65 countries. 

This network includes all other 29 OECD member countries. It also covers the vast majority of 

foreign trade and investment of U.S. businesses. 

 141 The tax systems of most other countries likewise endorse the arm’s length standard. The 

Organisation for Economic Co-operation and Development (“OECD”), for instance, explicitly 

incorporates the arm’s length principal in its 1995 Transfer pricing Guidelines as well as in the OECD 

Model Tax Treaty. 

142 Recently, the United States has entered into a series of bilateral tax treaties that eliminate 

withholding tax on dividends paid by one corporation to another corporation that owns at least 80 percent 

of the stock of the dividend-paying corporation (often referred to as “direct dividends”), provided that 

certain conditions are met. The elimination of withholding tax under these circumstances is intended to 

reduce further the tax barriers to direct investment between the two treaty countries. Many bilateral tax 

treaties to which the United States is not a party eliminate withholding taxes in similar circumstances. 

Over the last three years, the Senate has given advice and consent to ratification of U.S. treaties and 

protocols containing zero-rate provisions with the United Kingdom, Australia, Mexico, Japan, the 

Netherlands, and Sweden. In addition, the United States has recently signed, but has not yet ratified, 

protocols with Denmark, Finland, and Germany which all include zero-rate provisions.