The scoop on the Bush tax proposals.
If you are going to make a New Year's resolution, you might as well be ambitious about it. Indeed, for 2003, President George W. Bush has vowed to clean out the political closet and solve the problems of the world. Bush has promised to smack down Al Qaeda, shape up Saddam, nix the nukes in North Korea, and maybe even get the United Nations up off its collective fat butt to do something useful. All admirable goals, these, and with some serious effort and a dose of luck he may even be able to pull it off.
For sheer chutzpah, however, nothing tops Bush's proposal to address the follies of the Internal Revenue Code by, among other things, eliminating the double tax on corporate earnings. Talk about a dreamer! Who does this guy he think he is!
The irony, of course, is that almost every economist, Republican or Democrat, will privately admit that eliminating the double tax on corporate profits is good economic policy, because the current U.S. tax system causes serious distortions. Currently, profits of a so-called "C" corporation are taxed twice, first at the corporate level and a second time through a dividends tax at the shareholder level.
The corporate double tax is considered especially dumb policy because it distorts debt and equity markets. (Tellingly, almost every other advanced country avoids double taxation for precisely this reason.) A corporation that borrows capital and uses its profits to service the debt can deduct its interest payments, and thus corporate profits are sheltered by interest deductions at the corporate level, and the interest income is taxed only once, to the lenders. Thus, heavy debt leverage is a well-known mechanism to circumvent the double tax. By contrast, if a corporation raises capital by selling equity, the corporate profits are taxed twice, first as corporate income and second as dividends. This policy obviously promotes heavily leveraged (and economically vulnerable) corporations and punishes corporations with strong balance sheets. How much policy sense does THAT make?
Corporate boards know that shareholders would usually prefer to see corporate profits reinvested rather than distributed. This encourages corporations to retain earnings, even if it means using the money to pursue marginal and inefficient investments. (Shareholders would rather see the corporation invest $1 inefficiently, at a low rate of return, rather than receive a $1 dividend and promptly give almost 50% of it to the federal and state governments.) If no better idea comes to mind, the corporation can always use its surplus cash to buy back its own shares at what is usually a capital gains tax rate.
Significantly, while C corporations are whacked with the double tax, other business entities such as "S" corporations, limited liability companies (LLCs) and limited partnerships (LPs) offer both limited liability protection and so-called "pass through" taxation-meaning that business profits are passed through and taxed one time directly to the owners. In effect, these entities are corporations without the punitive corporate taxes.
So who chooses to be a C corporation these days? No one, if I can help it. As a tax lawyer, I am a fervent evangelist, converting everyone who is currently a C corporation to an S corporation, if possible, while encouraging all new businesses to start life as an LLC or an S corporation, and to hang onto that pass-through tax status for as long as possible.
Are there any good reasons to be a C corporation? The answer is no. Some years ago, C status provided a limited benefit to small businesses because owner-employees could deduct their health-care premiums on a pre-tax basis (a deduction not allowed for S corporations and partnerships). However, that advantage, which was never large, is being phased out and will disappear entirely in 2006. Indeed, the logic of avoiding C status is so compelling and clear-cut that a friend and I once considered-half-seriously-submitting a law before the Massachusetts Legislature that would make it illegal for a C corporation to own real estate in Massachusetts. The point was, holding real estate in a C corporation NEVER makes sense. Our proposal was the income-tax equivalent of a seat-belt law-we were going to save people from their own ignorance and foolishness.
Why, then, is any business a C corporation? There are two basic reasons. First, federal tax law requires that all publicly traded entities be taxed as C corporations. Thus, if you want access to U.S. capital markets, you accept double taxation as a toll charge. Second, many venture-capital investors want to invest in a C corporation, for specific reasons. Sometimes, the investor is a tax-exempt entity (such as a pension fund) and does not want the dreaded unrelated business taxable income. (Tax-exempt entities receive dividends tax free, but pass-through income is classified as unrelated business taxable income, or UBTI, and is subject to federal income taxation and, in large amounts, can cost the entity its tax-exempt status). Other times, the investors are foreign persons who do not want "effectively connected" income that will require them to file a U.S. tax return and pay U.S. taxes. A third reason-a little on the dumb side, but true-is that some venture-capital investors are comfortable taking preferred stock in a C corporation, have always done deals that way and don't want to change.
These reasons can be distilled down to one core reason: The company is either publicly traded or hopes to become publicly traded. In substance, then, the double-tax can be described as an awkwardly conceived levy on our capital markets. And, when you look at it that way, the double tax REALLY makes no sense.