Anthony Polito’s timely new work considers whether passthrough taxation should be made available to all non-publicly traded businesses, without regard to form of business entity, and whether such tax treatment should be mandatory.
Currently, most closely held businesses (except for those organized in the corporate form) may elect to benefit from a single level of taxation, whereas corporate business entities and most publicly traded entities are taxed as C corporations and subject to double taxation. As a result, newly-formed, non-publicly traded entities are only subject to subchapter C by choice. So when would an entity voluntarily subject itself to the double taxation regime? As the Article explains, a business would elect corporate taxation over passthrough taxation when an “insider shelter” tax strategy is available: namely, when the tax burden on a taxable corporate entity is less than on a passthrough entity.
This situation arises if the tax rate imposed on corporate income together with the shareholder-level tax rate levied on the distribution of profits from the corporation (taking into account the benefit of deferral) is less than the individual taxpayer’s marginal tax rate. This situation currently exists for many corporations that are owned by wealthy individuals, but have corporate taxable income of less than $335,000, which is taxed at lower corporate tax rates. Even owners of more profitable corporations may benefit from this strategy if they defer the distribution of profits for a sufficiently long period. This insider shelter tax strategy is undesirable in that it reduces potential government revenues, affects the distributive equity of our tax system, and creates allocative inefficiencies.
Most corporate tax reform discussions, including the recently released House tax bill, seek to lower the corporate tax rate. By increasing the tax benefits of using the corporate form, this type of corporate tax reform on its own is likely to exacerbate the inside shelter tax strategy. The recent House tax bill also lowers the tax rate applicable to passthrough entities. Although the Article does not discuss the effect of this type of change, a reduction in the pass-through rate is likely to partially mitigate the inside shelter tax problem. However, this change also introduces new tax avoidance techniques, additional administrative complexity and may move us further away from parity of taxation across business forms.
Polito ultimately concludes that mandating pass-through treatment for all non-publicly traded businesses would eliminate the inside shelter tax advantage, but Polito advises against this approach. According to the Article, “such a program would impose significant burdens on going-private transactions and perhaps inadvertent loss of public trading status.” Instead, Polito suggests several recommendations for reform that would advance the project of corporate tax integration, as well as address the inside shelter issue. Specifically, he concludes: (i) passthrough taxation should be extended to all non-publicly traded businesses on an elective basis; (ii) the various passthrough taxation models should be reexamined to consider the benefits of a single integrated passthrough regime; (iii) the transition from subchapter C to passthrough taxation should be a non-recognition event but the business entity itself should preserve historic basis and accumulated earnings and profits; and (iv) a split tax rate regime should be implemented with respect to C corporations where the combined corporate and individual tax rate equals (or slightly exceeds) the maximum individual tax rate that would apply in a fully integrated passthrough regime.
In short, this work provides a thoughtful analysis of the interplay between the corporate and passthrough tax regimes. Even though the recently released House tax bill do not contain any corporate tax integration provisions, Polito’s recommendations at least move us towards a de facto corporate tax integration and, more generally, improve the taxation of business enterprises.