Dividend Taxes, C Corporations and Other Bone-Headed Tax Policies –

Give President Bush his due: The man is not afraid of a challenge. Bush has loaded up his 2003 plate with a dog’s breakfast of ambitious tasks: 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. As they say at the circus, you would certainly pay to see that! But the Bush goal that really floors me is his proposal to eliminate the double tax on corporate earnings. He may be a dreamer, but it’s a dream that I support.

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 idea, because the U.S. tax system causes serious economic distortions. Currently profits of a so-called C corporation are taxed twice, first by an income tax at the corporate level and a second time by a tax on dividends at the shareholder level.

Behind the Curve

The corporate double tax is considered an 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. Thus, corporate profits are sheltered by interest deductions at the corporate level, and the interest income is taxed only once, to the lenders. 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 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.

While C corporations are whacked with the double tax, other business entities such as S corporations, limited liability companies (LLCs) and limited partnerships offer both limited liability protection and so-called “pass through” taxation. That means 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 elects 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 as long as possible.

Don’t Give Me a C

Are there any good reasons to be a C corporation? 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.

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 ultra vires and 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 stupidity.

Why, then, is any business a C corporation? There are two basic reasons. First, federal tax law has required, since 1986, that all publicly traded entities be taxed as C corporations. If you want access to U.S. capital markets, you have to accept double taxation as a kind of toll. Second, many venture capital investors want to invest in C corporations for specific reasons. Sometimes, the investor is a tax-exempt entity (such as a pension fund) and does not want the dreaded UBTI. (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.)

Dumb VCs

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.

The various reasons to be a C corporation can be distilled down to one reason: The company is either publicly traded or hopes to become publicly traded. In substance, then, the double tax is really just an awkwardly conceived tax on our capital markets. And, when you look at it that way, the double tax really makes no sense.

Democrats oppose the Bush tax proposal because it favors “rich people,” who are assumed to be its predominant beneficiaries. The truth, however, is a bit more complicated. First of all, most holders of publicly traded stock already don’t pay taxes on dividends. The two biggest shareholder categories are (1) pension funds or other tax exempt entities (including 401(k) plans and IRAs) and (2) other corporations, which enjoy a 70% corporate dividend exclusion. Only about 30% of publicly traded shares are in the hands of individuals who pay a full dividend tax.

More importantly, rich people-known in securities law parlance as “accredited investors”-have lots of investment alternatives, including the ability to invest in private pass-through entities, and they enjoy a single level of taxation on business profits. People with serious money also often own real estate, which enjoys all kinds of tax incentives, and bonds, which are really a form of pass-through taxation.

Middle-class and working-class individuals also like to save and invest, but these individuals aren’t accredited investors and don’t have access to private equity deals. They are in effect only allowed to invest in publicly traded stocks, which means their investments are always going to be subject to double taxation. So, who is penalized the most by double taxation, the rich or the middle class?

Bush’s biggest problem is that his tax proposals-which include eliminating the “marriage penalty” and accelerating some of the 2001 tax cuts-will cost the federal government anywhere from $600 billion to $900 billion in revenue. And, the question is whether that revenue should be “spent” fixing tax distortions or on something else.

On Taxes and Motorcycles

I personally favor Bush’s proposals, especially eliminating the double tax, even though it is probably against my self-interest. Double taxation creates lots of work for tax lawyers, so we view it the same way that doctors view motorcycles and dentists view candy. First of all, I am always in favor of trying to fix the Internal Revenue Code. The code itself is a mess-a hugely complicated jumble of often-incoherent objectives and philosophies. Part of the problem is that we want the code to do too much: You can make a very credible argument that the core document embodying the American social compact today is not the U.S. Constitution but the Internal Revenue Code.

Manifesto Destiny

The code has become the de facto manifesto of American governance, our preferred device for allocating public resources and costs. The code encourages all kinds of behavior: having children, saving money for retirement, building low-income housing, using alcohol as fuel, owning your own home. The code also penalizes behavior, sometimes in bizarre ways: It penalizes marriage when both spouses work, penalizes people who rent instead of own and, most famously, it penalizes people who work over those who don’t.

Doing all the tasks we assign to the code fairly and well ought to be a reasonably high priority in this country, and the Bush proposals generally head in the right direction. On the other hand, there are lots of social problems that need addressing just now, and fixing the idiocies of tax law is only one of them. So we seem destined to embark, once again, on a bitter and acrimonious debate over the Internal Revenue Code, discussing how we raise government revenues and who foots the bill, with opinion this time divided over dividends.

Joseph “Jay” Darby is a partner in the Boston office of law firm Greenberg Traurig (www.gtlaw.com). He specializes in three areas: tax, corporate/securities and intellectual property. He received his law degree from Harvard Law School in 1978 and a bachelor’s in mathematics from the University of Illinois in 1974. Darby is the author of several books and has written more than 500 articles for magazines and newspapers, including Hemispheres and Worth.