losses with their other tax items. On the other hand, the owners must pay tax at their tax rates on the business income as it arises. Obviously, these features of conduit taxation may or may not be advantageous, depending upon the applicable tax rates and other factors. As between subchapters K and S, there are a number of significant tax differences. Under subchapter K but not subchapter S, (1) firms may specially allocate their tax items among their owners,' (2) entitylevel debt may be included in the basis of the owners in their ownership interests, and (3) the inside basis of a firm's assets may be adjusted upon the death of an owner, a transfer of ownership interests, or a distribution from the firm.' In addition, a contribution or distribution transaction between the owners and the firm more likely results in the nonrecognition of gain or loss under subchapter K than subchapter S. On the other hand, only subchapter K firms are subject to a series of complicated rules designed to prevent tax advantages in selected situations." Further, S corporations, like C corporations, can convert to public status without tax consequences and can participate in a tax-free reorganization with a C corporation. Subchapter K firms cannot participate in reorganizations and, when they go public, the transaction may or may not be wholly tax-free. After taking into account all of the differences, subchapter S is usually less advantageous than subchapter K but in certain cases, it may be more advantageous. 6 8 The elective tax treatment undermines both equity and efficiency objectives for the income tax. Although in theory, similarly situated businesses have an equal opportunity to be treated in the same tax-advantageous manner under current law, the practical reality is probably to the contrary, due to disparities in the quality of advice the businesses receive. By permitting such disparate tax choices without any apparent underlying, conceptual foundation, current law simply provides a tax benefit for the well-advised and a trap for the ill-advised. There is no particular policy reason why the taxation of private business firms should result in the minimization of tax liabilities for only the well-advised. Moreover, current law violates vertical equity norms. By giving well-advised private business owners a range of tax liabilities to choose from, current law by definition cannot impose the "proper" level of tax on them based upon vertical equity principles. The elective nature of current law fosters inefficiency in several ways. First, not all businesses are provided with the same tax benefit of being able to choose their tax liability within a range of options. Neither public firms nor sole proprietors, for example, are provided 3 Compare I.R.C. § 704(a) and (b) with §§ 1366(a)(1), 1377(a). 5 6 See I.R.C. § 752. See I.R.C. § 754. Compare I.R.C. § 351 with § 721 and §§ 1368, 302, 331, 311, and 336 with §§ 731, 704(c)(1)(B), 737, 707(a)(2)(B), and 751(b). 7 See, e.g., I.R.C. §§ 704(c), 707(a)(2) and (b), 724, 731(c), 732(c), 735, 737, and 751. Subchapter S firms are, however, subject to the collapsible corporation provisions of section 341. See I.R.C. § 1371(a). 8 See I.R.C. § 1371(a). with the same degree of flexibility in determining the amount of their income tax liabilities. Thus, current law may distort the economic decisions of firms near the boundary of those eligible for the tax choice, thereby potentially causing deadweight losses. Indeed, private firms were already generally taxed more favorably than either of the other two types of businesses prior to the check-the-box regulations; the new choice for private firms simply tilts the tax scales further in their favor. Second, as previously noted, not all eligible firms may make the optimal tax choice due to a variety of factors. But if, for whatever reasons, firms differ in their access to the tax minimization techniques, then allocative distortions across firms may result. Finally and most importantly, current law is unnecessarily complicated and costly. To minimize tax burdens, businesses must consider the consequences of three possible operating rule systems on their anticipated business activities and learn to comply with the rules selected. The IRS must administer and give oversight to the three different systems. Further, the planning, compliance, and administration costs are ongoing in that businesses may have the opportunity to change their choice of rule structure as their business activities evolve or as other aspects of the law change. Reducing the number of choices should simplify the law and improve its efficiency by decreasing transactions costs. In conclusion, the current system of taxing the income of private business enterprises has evolved into one that is inconsistent with its historical roots and violates important tax policy objectives. With the link between taxes and organizational form broken, there is no longer any clear justification to maintain all three systems of taxation. The next part of this paper describes why all private firms should generally be treated as conduits for income tax purposes. II. Taxation of Private Business Firms as Conduits The two basic approaches to taxing the income of a firm are conduit and entity taxation. Under conduit taxation, the firm is not treated as a taxpayer separate and apart from its owners. Rather, the firm is transparent for tax purposes; its various tax items pass through to the owners of the firm, the real (and only) taxpayers in interest. Under current law, both the partnership tax rules of subchapter K and the subchapter S rules for certain closely held corporations implement a version of conduit taxation, with subchapter K being a closer approximation of the approach. In contrast, under entity taxation, the firm is treated as a taxable entity in its own right. Current subchapter C, under which the firm is taxed on business income as it arises and then the owners are taxed again upon a distribution of profits to them, is an example of entity taxation. However, entity taxation need not result in double taxation. For example, in 1992, the Treasury Department recommended exploration of an approach, termed the Comprehensive Business Income Tax (CBIT), that would subject the income of all business entities (except for extremely small ones in terms of gross receipts), including sole proprietorships, partnerships, corporations, and firms organized in other business forms, to a single, comprehensive entity-level tax, with generally no further income tax consequences at the owner level. The Treasury estimated that CBIT would produce greater welfare gains than any other form of corporate integration, including Treasury's version of partnership-style integration." 10 Another example of an entity tax approach is the imputation credit system of integration recommended by the ALI Reporter's Study. Under that approach, an entity-level tax on business income would be imposed pending a distribution, at which point there would be a reconciliation of the entity and owner-level taxes to prevent double taxation and to insure that the income is ultimately taxed at the owner's tax rate. Thus, undistributed income would be subject to an entity tax and distributed income would be temporarily subject to one. Business losses would not pass through to owners. Although the ALI Reporter's recommendation only addressed the taxation of corporations, the approach could in theory be made applicable to all business firms, no matter how they are organized. The following sections compare the advantages and disadvantages of conduit and entity taxation. To provide a fair comparison, the discussion assumes that the entity tax system would be implemented without imposing double taxation. Although the choice is a very close one, we conclude that all private firms generally should be taxed in accordance with the principles of conduit taxation. A. Equity and efficiency. -- Tax policy principles of equity and efficiency both seem to favor conduit over entity taxation of a firm. An equity argument begins with the proposition that people, and not entities, pay taxes, and that people should pay income taxes in accordance with their ability to pay. Two important objectives relating to the taxation of business income flow from this proposition. First, the owners of a firm should be entitled to net their income, deductions, and losses from other sources with their share of the firm's tax items in order to determine their overall ability to pay. Second, the resulting net tax items of the owners, including their share of the firm's tax items, should be taxed at rates consistent with their ability to pay. By disregarding the entity for tax purposes and taxing owners directly on their share of the entity's tax items, conduit taxation potentially accomplishes each of these two goals. In contrast, entity taxation does not satisfy either goal. A single entity tax rate, by definition, cannot be made consistent with the ability to pay of the owners in any situation where the owners have differing abilities." In addition, entity taxation limits the ability of owners to net their tax items with their share of the firm's tax items, thereby precluding a proper determination of their ability to pay. For example, owners would not be able to utilize any U.S. DEP'T OF TREASURY, INTEGRATION OF THE INDIVIDUAL AND CORPORATE TAX SYSTEMS: TAXING BUSINESS INCOME ONCE (1992) [hereinafter TREASURY INTEGRATION REPORT]. 10 See AMERICAN LAW INSTITUTE, FEDERAL INCOME TAX PROJECT: INTEGRATION OF THE INDIVIDUAL AND CORPORATE INCOME TAXES -- REPORTER'S STUDY OF CORPORATE TAX INTEGRATION BY ALVIN C. WARREN (1993) [hereinafter ALI REPORTER'S INTEGRATION STUDY]. 11 This statement is true even under a system like the ALI Reporter's Study where the entity tax plays a withholding role. Pending a distribution, taxation of the business income is generally taxed at the wrong rate. available deductions to reduce their share of the firm's income in calculating their taxable income. Similarly, owners could not use their share of a firm's losses to reduce their income from other sources. In short, entity taxation is not consistent with equity principles for the income tax. An efficiency argument in favor of conduit taxation is that it conforms more closely than entity taxation to how proprietorships are taxed and therefore minimizes distortions in the choice of business form. This is because sole proprietors are taxed directly on their proprietorship income as it arises and are entitled to deduct currently any losses of the enterprise as they arise. The business itself is not subject to a separate federal income tax. Of course, to conform to entity taxation, it would theoretically be possible to treat a proprietorship as a taxpayer separate from its proprietor. As noted, the 1992 Treasury report made exactly that recommendation. But such a system would be very problematic, depending upon the applicable tax rate structure. For example, suppose all proprietorships were treated as taxpayers separate from their proprietors and made subject to a flat 30 percent income tax rate. In that case, proprietors in marginal tax brackets higher than 30 percent would be encouraged to redesign their economic arrangements to generate proprietorship income for themselves rather than wages or other income. Meanwhile, proprietors in marginal tax brackets less than 30 percent would be encouraged to employ the opposite strategy. For instance, they might increase the level of deductible salary payments paid by their proprietorship to themselves. Given the absence of arm's length dealing between a proprietor and proprietorship, it would presumably be extremely difficult for the IRS to monitor and prevent purely tax-motivated arrangements of this sort. Taxing the proprietorship's income in a progressive manner would not improve matters because there still would not be any necessary correlation between the proprietorship's tax rate and the proprietor's ability to pay. The proprietor may well have income, deductions, or losses from other sources which would need to be taken into account, along with the proprietorship income, to determine the proprietor's ability to pay. It is for this same reason that the graduated tax rate structure under which many corporations are taxed today does not carry out any vertical equity objective. Assuming, then, that proprietors are to continue to be taxed directly on their business income and losses, it follows that businesses with more than one owner should likewise be taxed as conduits. If the proprietorship is not treated as a separate taxpayer, it is difficult to see why, say, a two-person general partnership should be so treated. Further analogies then might suggest that no business firm should be separately taxed. As an economic matter, if proprietors are taxed directly on their proprietorship income but partnerships (and not the partners) are taxed on the partnership income, then the tax system will have created an undesirable barrier against or inducement in favor of the pooling of resources via a partnership. True, the state law characteristics of a proprietorship may be different from those of many other business forms. Unlike a proprietorship, other forms of business organization are treated for a number of state law purposes as legal entities separate from their owners. But certain of these state law characteristics are only default positions, supplying a rule in the absence of any contrary agreement by the parties. Thus, they do not provide a very solid basis for determining the manner in which a firm should be taxed. Moreover, the clear message of the check-the-box regulations is to ignore state law differences among private business entities in making that determination. At least for tax purposes, then, it would seem that proprietorships and other private business firms should be treated as similarly as possible. Conduit, and not entity, taxation of private firms accomplishes that goal. In formulating its 1992 recommendation, the Treasury Department articulated a different efficiency consideration, one that it believed constituted a rationale for entity taxation: Assuring that corporate income is taxed once, but only once, does not require that ... Economic efficiency suggests that all capital income should be taxed at the 12 But to the extent this rationale is based on the efficiency of taxing all income, whether from capital or labor, in a uniform manner, it may conflict with equity objectives of the income tax, which may dictate that all income should not be taxed at the same rate. If, on the other hand, the rationale is based on the more limited proposition that it is efficient to tax only capital income uniformly, the equity objection is still potentially present, although less severe. Moreover, an entity tax approach may not be a particularly effective way of accomplishing the more limited goal. The basic problem is that various income-shifting devices, especially available to the owners of private, closely held firms, easily permit taxpayers to muddy the distinction between capital and labor income. Some business income of a firm may in reality be income from the labor of the firm's owners, and some labor income may in reality include capital income from investment in a firm. Hence, taxing a firm's income at the same rate may not be an effective method of taxing all capital income, and only capital income, in a uniform manner. In summary, equity considerations clearly favor conduit over entity taxation. Efficiency considerations are a little more mixed. Given how proprietorships almost surely must be taxed, conduit taxation minimizes distortions in the choice of business form. Entity taxation promotes greater uniformity in taxation, but only through a potential conflict with equity objectives of the income tax. And entity taxation may not be an effective way of taxing only capital income uniformly, if that is the efficiency objective. B. Compliance and administration. -- Considerations of tax compliance and administration provide a preference for entity taxation over conduit taxation. One important 12 TREASURY INTEGRATION REPORT, supra note, at 12-13. |