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All You Ever Wanted to Know About U.S. Income Taxation of Business Enterprises Jack S. Levin

All You Ever Wanted to Know About U.S. Income Taxation of Business Enterprises Jack S. Levin Donald E. Rocap Kirkland & Ellis LLP 3/8/05. Table of contents Page no. _. What has shaped U.S. business tax system . . . 3 5 sources of U.S. business tax complexity . . . . 5

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All You Ever Wanted to Know About U.S. Income Taxation of Business Enterprises Jack S. Levin

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  1. All You Ever Wanted to Know About U.S. Income Taxation of Business Enterprises Jack S. Levin Donald E. Rocap Kirkland & Ellis LLP 3/8/05 KIRKLAND & ELLIS LLP

  2. Table of contentsPage no._ • What has shaped U.S. business tax system . . . 3 • 5 sources of U.S. business tax complexity . . . . 5 • A few examples of undue complexity . . . . . . . 11 • Gov’t failures and some possible solutions . . . 42 KIRKLAND & ELLIS LLP

  3. What has shaped U.S. business tax system Competing pressures: (a) Gov’t seeks to maximize revenue (b) Taxpayers seek to minimize payments (c) System should be, and should appear to be, fair (d) Gov’t often seeks to encourage favored conduct (risk capital investment, R&D, U.S.-based production, capital equip purchase) • and discourage disfavored conduct (high exec comp, moving hdqs and/or employment offshore) (e) Minimize complexity and compliance costs • Our worst dismal failure KIRKLAND & ELLIS LLP

  4. Conclusion • Every spec’l provision to encourage/ discourage conduct creates a special rate, ded’n, or credit, thus creating: • complexity • compliance cost • volumes of new regulations and definitions • shelter schemes to obtain the benefit • appearance of unfairness to those not obtaining the benefit KIRKLAND & ELLIS LLP

  5. C corp • S corp • partnership • LLC • proprietorship 5 sources of U.S. business tax complexity • At least 5 different types of entities engage in business and they are subject to 3 very different tax regimes KIRKLAND & ELLIS LLP

  6. There are 2 principal sources of financing for business • debt and • equity (common and pfd stock) which are treated radically differently for tax purposes KIRKLAND & ELLIS LLP

  7. There are 3 completely different merger/acq’n systems for taxing a combination of 2 business enterprises (a) Tax free (b) Taxable stock sale (c) Taxable asset sale and these 3 systems reach very different results depending on: (1) whether target (T) is C corp, S corp, or p’ship/LLC/proprietorship, and (2) on form of transaction (asset acq’n or stock acq’n) KIRKLAND & ELLIS LLP

  8. A welter of different tax rates (at least 9) for different types of income (depending on whether favored or disfavored) • and a slew of different treatments for favored ded’ns • and a slew of different treatments for disfavored losses/ded’ns KIRKLAND & ELLIS LLP

  9. Recurring pattern: Gov’t adopts tax incentive • Then taxpayers squeeze conduct into favored category to use (or abuse) incentive • Then gov’t adopts increasingly complex and lengthy rules to define favored category w/ more precision • Gov’t also tends to split the baby by retaining tax incentive, but using AMT system to partially penalize those who claim incentive KIRKLAND & ELLIS LLP

  10. Each C corp must calculate tax under both of 2 very different complex sets of rules • Regular income tax rules at rates up to 35% • Corporate AMT rules at rates up to 20% and pay larger of the 2 amounts Existence of 2 radically different tax codes makes rational tax planning/admin/ compliance geometrically more difficult KIRKLAND & ELLIS LLP

  11. A few examples of undue complexity KIRKLAND & ELLIS LLP

  12. * Spec’l regimes for regulated investment companies (RICs) and real estate investment trusts (REITs) not herein discussed • Five different types of business entities subj’d to three different tax regimes* (a) C corp • Subj’d to double taxation: (1) Corp-level tax (max 35% corp rate) on: (i) annual earnings and (ii) gain on sale of the business assets (2) S/H-level tax (max 15%) on: (i) dividend distrib’n out of earnings and (ii) gain on sale of stock (including undistrib’d earnings which make stock more valuable) KIRKLAND & ELLIS LLP

  13. (b)P’ship/LLC/proprietorship • Flow-thru taxation • No entity-level tax • Equity owner subj’d to tax on share of entity’s income (max 35% indiv’l rate) • Entity’s accum’d income increases equity owner’s basis in entity, so retained earnings not taxed on sale of entity • No arbitrary limitations, as there are on S corp (as discussed below), but publicly traded p’ship or LLC taxed as C corp KIRKLAND & ELLIS LLP

  14. (c)S corp • Flow-thru taxation, similar (but not identical) to p’ship/LLC/ proprietorship • But if entity is former C corp • gain on asset sale subj’d to both(1) entity-level tax and (2) equity owner-level tax (like C) • but only on appreciation when entity switched from C to S KIRKLAND & ELLIS LLP

  15. Arbitrary and complex limitations on ability to use S • No S corp S/H can be p’ship, LLC, corp, non-resident alien • Only 1 economic class of S corp stock (so no pfd stock allowed) • Only 100 S/Hs (but up to 6 generations of family members can count as only 1) • If S corp violates any of above limitations, automatically turns into C corp (subj to double tax) KIRKLAND & ELLIS LLP

  16. (d)Add’l rule • Can’t transform C or S corp into p’ship/LLC w/o triggering tax on all appreciation • i.e., treat transformation to p’ship/ LLC as if all C or S corp assets sold at FV KIRKLAND & ELLIS LLP

  17. Two principal sources of business capital treated radically differently (a) Debt financing • Interest exp is ded’ble, providing shelter against corp-level tax • Subj to 6 complex hurdles discussed in (e) below • Result: single tax on debt holder KIRKLAND & ELLIS LLP

  18. (b) Equity financing • Dividends on common or pfd stock are not ded’ble at corp-level • Result: double tax on dividends • Entity-level tax up to 35% • S/H-level tax now 15% • 2d tax (S/H-level) due when S/H receives dividend or sells stock KIRKLAND & ELLIS LLP

  19. (c) Because C corp equity financing treated less favorably than debt financing for tax purposes, • C corps are motivated to overleverage, i.e., borrow more and raise less equity This is one of the ways some Code provisions encourage undesirable conduct KIRKLAND & ELLIS LLP

  20. * But where debt holder is ERISA plan, there is ultimately tax on ERISA plan participant (when benefits paid out) ** Where equity holder is ERISA plan, ultimately 2nd tax on plan participant (when benefits paid out) (d) When debt holder or equity holder is unrelated foreign person or TEO (e.g., ERISA plan, university endowment) (i) No tax on corp’s int payment • No tax at corp level because int ded’ble, nor at debt holder level because TEO* (ii) Single tax on corp’s dividend payment • Tax at corp level because dividend not ded’ble, but no tax on equity holder because TEO** KIRKLAND & ELLIS LLP

  21. (e) Basic premise for differing treatment of debt and equity is perfectly rational: • Because debt is liability, interest yield is expense • Because equity is not liability, equity yield is not expense But ability to place either debt or equity label on investment capital offers enormous tax planning opportunities So gov’t has responded w/ series of complex rules to treat debt like equity where too-closely resembles equity and to treat equity like debt where too-closely resembles debt KIRKLAND & ELLIS LLP

  22. In particular, corp must overcome 6 complex interest ded’n hurdles: (i) Common law/Code §385 subjective debt-equity rules (ii) Code §163(e)(5) for high-yield debt w/ non-cash pay feature (iii) Code §279 for subord’d acq’n debt w/ conversion or warrant feature KIRKLAND & ELLIS LLP

  23. (iv) Code §163(j) (test #1) for debt held by > 50% S/H which is TEO or FP or p’ship/LLC w/  10% TEO/FP ownership (v) Code §163(j) (test #2) for debt supported by > 50% S/H which is TEO or FP (vi) Code §163(l) for debt w/ subst’l int or prin’l payable in, or by reference to, equity KIRKLAND & ELLIS LLP

  24. (f) Above debt/equity distinctions are gen’ly more important for corp than for p’ship/LLC/proprietorship KIRKLAND & ELLIS LLP

  25. (g) Lease financing for capital equip is a 3d source of business capital • Lessor in effect loans money to business, in exchange for future stream of rental payments (like principal and interest) • But lessor takes title to capital equip, so entitled to accelerated depreciation dedn’s, which gen’ly exceed lessor’s rental income in early years, creating front-end tax losses and sheltering lessor’s other income in early yrs • Low (or zero) tax bracket business often leases (rather than buys) capital equip to shift accelerated depreciation to high income lessor KIRKLAND & ELLIS LLP

  26. So gov’t (to protect revenues and accomplish perceived fairness) promulgates complex rules to limit such transfer of tax benefits from lessee to lessor: • AMT slower depreciation • Rules to determine “true” owner for tax purposes • Passive activity loss limitation KIRKLAND & ELLIS LLP

  27. Mgrs and acq’ns (a) Theoretical underpining for tax-free org’z’ns and reorgs: • Exchange of one property for another is taxable event, triggering appreciation • But to facilitate business org’z’ns and reorgs, permit nonrecognition on (e.g.) combination of 2 enterprises, or division of 1 enterprise, w/ old owners receiving stock in new When taxpayers then seek to extend tax-free rules to circumstances resembling sale, gov’t responds w/ increasingly complex and lengthy rules KIRKLAND & ELLIS LLP

  28. (b) §368 reorg’z’n rules • Available only to C or S corp, not to p’ship/LLC/proprietorship • 9 complex and arbitrary pigeon holes, which turn on formalities such as: (i) whether transaction is acq’n of T stock, acq’n of T assets, merger and (ii) whether BuyerCo acquires at parent or subsidiary level: KIRKLAND & ELLIS LLP

  29. Two-party merger under §368(a)(1)(A) • Forward subsid’y merger under §368(a)(2)(D) • Reverse subsid’y merger under §368(a)(2)(E) • Two-party stock-for-stock exchange under §368(a)(1)(B) • Three-party subsid’y stock-for-stock exchange under §368(a)(1)(B) KIRKLAND & ELLIS LLP

  30. Two-party stock-for-asset exchange under §368(a)(1)(C) • Three-party subsid’y stock-for-asset exchange under §368(a)(1)(C) • Non-divisive transfer of assets to commonly controlled corporation under §368(a)(1)(D) • Divisive transfer of assets to controlled corporation under §368(a)(1)(D) KIRKLAND & ELLIS LLP

  31. Each pigeon hole has combination of silly distinctions not contained in other pigeon holes: • Whether substantially all of T’s assets must be acquired • Permissibility of non-stock consideration • Whether stock consideration must be voting stock • Percentage of T’s stock that must be acquired KIRKLAND & ELLIS LLP

  32. (c) Rules for tax-free contribution of assets to, and distribution of assets by, business entities also enormously complex and differ depending on nature of assets and type of business entity (i) §351 corporate formation rules • Tax triggered if “control” test flunked, if corp is an “investment company,” or if excessive liabilities are assumed KIRKLAND & ELLIS LLP

  33. (ii) §721 p’ship/LLC formation rules • Tax triggered if treated as “disguised sale” (iii) §355 spin-offs • Tax triggered if flunk “control,” “business purpose,” “active business,” “device,” or other tests or if distrib’n is treated as occurring in connection with certain stock acq’ns KIRKLAND & ELLIS LLP

  34. (d) Taxable acq’n • Tax result completely different than where transaction fits a tax-free acq’n pigeon hole (described above) • Tax result varies greatly depending on form of target entity (T) • and whether BuyerCo acquires T stock or T assets (i) Where T is p’ship/LLC/ proprietorship, BuyerCo takes asset SUB, w/ no double tax on sellers KIRKLAND & ELLIS LLP

  35. (ii) Where T is C corp, (i) BuyerCo takes COB, w/ single tax on sellers, for stock acq’n and (ii) SUB, w/ double tax on sellers, for asset acq’n (iii) Where T is S corp, result turns on whether S corp was C corp at any time during past 10 yrs KIRKLAND & ELLIS LLP

  36. * Capital gain means long-term capital gain throughout this paper • Welter of tax rates and other spec’l treatments (a) Normal ordinary income top rate is 35% (for indiv’l or C corp) (b) Welter of different tax rates for different types of income (depending on whether more or less favored than normal ordinary income): • 0% for muni bond interest • 14% for indiv’l’s gain on “small business stock” • 15% for indiv’l’s capital gain* and qualified dividend income KIRKLAND & ELLIS LLP

  37. 32% (after several yr phase in) for U.S. net production income • 36% for indiv’l’s comp income (incl’g 1.45% medicare tax) • 38% for indiv’l’s self employment income (incl’g 2.9% medicare tax) • Add’l 20 points for indiv’l’s disqualified deferred comp • Add’l 20 points for indiv’l’s golden parachute comp KIRKLAND & ELLIS LLP

  38. (c) As one example of complexity caused by spec’l tax break to encourage conduct, 10/04 legis’n (new Code §199) seeks to encourage U.S.-based production activities by granting reduced tax rate on U.S. net production income • 35% rate phases down to 32% over several yrs • Creates tremendous acctg/admin/audit complexity KIRKLAND & ELLIS LLP

  39. Rate reduction covers business net income from: (i) sale, lease, other disposition of: (A) tangible personal prop'y, computer software, or sound recording • mfd, produced, grown, or extracted by taxpayer w/in U.S. (B) motion picture film or tape • produced by taxpayer in U.S., w/ no "actual sexually explicit conduct" (C) elec'y, nat'l gas, potable water • produced by taxpayer in U.S. KIRKLAND & ELLIS LLP

  40. (ii) U.S. construction activities (iii) engineering or architectural services in U.S. for U.S. construction project KIRKLAND & ELLIS LLP

  41. Complexities: • Need to calculate net income from covered activity, i.e., allocating exps betw covered (U.S. production) and non-covered activities (U.S. retail, wholesale, service, and transportation income and foreign production) • E.g., exec comp, hdqrs overhead, R&D • E.g., product which incorporates both U.S. goods/services and foreign goods/services • E.g., allocating net income to non-covered retailing, wholesaling, transportation, as opposed to U.S. production KIRKLAND & ELLIS LLP

  42. Gov’t failures and some possible solutions (a) Failure of gov’t to make hard decisions • resulting in multitude of rules, definitions, exceptions, qualifications, and sub-categories, rather than one (or few) rules • E.g., AMT rules laid on top of regular tax rules • To extent AMT rules are sensible, incorporate them into regular tax • To extent not sensible, discard!! KIRKLAND & ELLIS LLP

  43. E.g., C corp interest ded’bility, but punctuated by 6 complex exceptions • At least rationalize the 6 • E.g., 9 complex pigeon holes defining tax-free reorg’z’ns • At least rationalize the 9 KIRKLAND & ELLIS LLP

  44. E.g., consider whether rate reduction for U.S. net production income and other spec’l rates, deductions, etc. worth signif’t increase in acctg/admin/dispute costs • or whether a broader tax base w/ lower rates and no CG/OI distinction (as in Reagan 1986 legislation) might be better • E.g., consider whether, given availability of LLC form, the separate S corp tax regime is worth the added complexity • E.g., consider whether all business entities should be governed by a unified single-tax regime KIRKLAND & ELLIS LLP

  45. (b) Failure of gov’t to stick w/ decisions once made • resulting in hundreds of law changes each yr (many not really nec’y), i.e., churning the tax law • E.g., sunsets for Bush tax reductions • E.g., on again, off again R&D credits and bonus depreciation KIRKLAND & ELLIS LLP

  46. (c) Gov’t efforts to make social policy through complex tax distinctions • Golden parachute tax penalties for exec comp related to change in corp ownership • incl’g 20 points extra tax on exec and no corp ded’n • Limiting to $1m/yr public co’s ded’n for comp to each of 5 top execs • w/ no similar limitation on comp to (e.g.) athlete or actor, nor on expenditures for (e.g.) advertising or travel KIRKLAND & ELLIS LLP

  47. 10/04 tax penalties for exec receiving deferred comp not w/in statutory pigeon holes • incl’g 20 points extra tax on exec • Denying rate reduction for U.S. net production income for “actually sexually explicit” movie • making IRS auditors arbiters of “actually sexually explicit” • one example of assigning to IRS issues its auditors are neither trained nor suited to enforce KIRKLAND & ELLIS LLP

  48. (d) Complexity, unfairness, and churning breed contempt for tax law • E.g., taxpayer disadvantaged by tax-law change questions why change nec’y and feels aggrieved • Hundreds of changes each yr mean millions of taxpayers feel aggrieved each yr KIRKLAND & ELLIS LLP

  49. (e) When a tax principle is submerged in flood of constantly changing legislative and regulatory rhetoric, • artificial shelters grow by seizing on a few choice words out of the verbal flood KIRKLAND & ELLIS LLP

  50. (f) While tax complexity inevitable (because taxes inherently complex), • much more gov’t effort nec’y to minimize (rather than geometrically multiply) complexity KIRKLAND & ELLIS LLP

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