TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Thursday, April 24, 2014

Undistributed Dividends and the Ability-to-Pay Principle

Limor Riza (Carmel Academic Center School of Law), Should Tax Law Mind Minority and Monitor Majority: The Case of Undistributed Dividends and the Ability-to-Pay Principle, 13 Hous. Bus. & Tax L.J. 86 (2013):

This paper analyzes the tax problem of undistributed dividends through the agency problem lens. Or actually, vice versa. It utilizes both corporate governance tools and tax rationales to address the taxation of undistributed dividends in closely held corporations. The joint discussion of both fields is uncommon and has, thus far, been employed mainly to explain the problem of two-tier taxation or problems occurring in large corporations. Not only is the cumulative discussion of both corporate governance and taxation uncommon, but the conclusion that these legal fields are coherent is even rarer.

The paper argues that taxing all shareholders--both minority and majority--on undistributed dividends deviates from the ability-to-pay principle and thus is inequitable. More specifically, the paper examines how the ability-to-pay principle can justify the taxation of undistributed dividends in closely held corporations where conflicts between minority shareholders and majority shareholders may arise. It discusses both the taxation of undistributed earnings at the shareholder level and at the corporate level, and restricts itself to the agency problem of dividend deprivation, or non-distribution.

The division between ownership and control in closely held corporations, when minority shareholders are exploited, undermines the justification of taxing minority shareholders on undistributed-deemed dividends. Thus, it is argued that the above question is linked to the agency problem, and the power to control dividend payments. Namely, it is claimed that whenever an agency problem occurs the ability-to-pay principle should be understood in terms of the ability to control dividend payments. As a result,*87 to achieve equitable taxation, deemed dividend distribution rules should not be applied to minority shareholders.

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