Eliminating the Tax on Dividends: A Differenct Perspective [The Bush Tax Plan Intentionally (or Not) Revives a Dormant Tax Reform Movement!]

Politics aside, what is the best, and the worst, that could happen if the Bush proposal to eliminate the tax on dividends were enacted? It would be a significant first step in an arguably much-needed major overhaul of our taxation of business and investment income. While it is billed as a stimulus to our economy, and while many are labeling it as a gold-mine for the rich, the plan has the potential of greatly minimizing the complexity and inefficiency of the use of partnerships, limited liability companies (generally taxed as partnerships), and Subchapter S elections, and enacting a more rational structure for taxing business income. Actually, the majority of non-corporate business investors now pay far less in income taxes than those who invest in taxable corporations. The emergence of the state enacted limited liability company, coupled with the IRS acceptance of these "pseudo" corporations as partnerships for income tax purposes has left the business tax structure discriminatory against the traditional corporation. The idea of reducing the so-called "double-tax" on corporate income would be a major force in striking at the heart of non-sensical pass-through entities, which have had their field day in avoiding double taxation and in creating tax loss shelters for non-corporate investors. Evaluating the Bush plan will take much more than a fiscal impact analysis. The plan's true advantage lies in the fact that it begins to question why many partnerships are permitted to allocate income and losses to those partners who gain most tax benefit, thereby decreasing the Federal and states revenue. The Bush plan must also address losses for all investors in both corporate and partnership entities. The IRS Statistics of Income for 1998 show that nearly one-half of partnerships reported operating losses, with a significantly high percentage of real estate, finance and certain insurance partnerships reporting large losses. Partnerships, as a whole, reported $1 trillion in assets, but showed a net return of less than 1%. "S" Corporations, on the other hand, a single-tax entity with many more restrictions than partnerships, reported a 12% return on their investments. The case for pass-through over entity level taxation fails to acknowledge these facts and more particularly minimizes the connection between tax-avoidance and the use and abuse of the partnership structure. The argument that the dividend exclusion will hurt the states is somewhat specious, since the states are already losing more tax revenue by creating single-tax structures, such as the LLC and other partnerships. The Plan can be vastly improved and made more acceptable to those who now oppose it, by considering the additional reforms discussed in the monograph I am currently preparing on the subject; this monograph will analyze 1) the treatment of capital gains and losses, 2) revising the tax-free state and local bond interest exclusion (without hurting the states' ability to borrow), 3) reforming the patch-quilt non-recognition provisions of the Code and thereby yielding more tax revenue than the present outdated and inefficient tax deferrals, 4) rationalizing the treatment of foreign investment in the United States, and 5) the disparity in treatment between "S" corporations and partnerships, including the ban on foreign investors in "S" corporations, but not in partnerships and LLC's, the one-class of stock requirement in "S" but not in other pass-through entities, and the treatment of debt in "S" and partnerships. A positive aspect of Bush plan is that even if enacted without these additional reforms, it will automatically generate an agenda for these changes in years ahead. In other words, not taxing dividends should help us understand why these other changes would be required in a more rational system. Thus, the Bush plan, with all its faults, is a move in the right direction for reasons not yet addressed. Those who have opposed the proposed dividend exclusion have overlooked the fact that it opens a door to the type of tax reform that the naysayers should welcome. This monograph will incorporate the Bush plan into a larger analysis of how we should change the way we tax our businesses and their investors, without placing irrational emphasis on the form of entity used. Its goal is to demonstrate that the current tax law already has a significant revenue loss that can be reversed by changing the structure for taxing ALL business and investment activity once, at the entity level. The President's plan does get us closer to the way business is taxed worldwide. Moreover, it will most likely require us not only to change the content of what is now being taught in corporation and partnership tax courses, but also to revise (and hopefully simplify) the way we practice tax law.