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Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 1 All You Ever Wanted to Know About U.S. Income Taxation of Business Enterprises Jack S. Levin.

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Presentation on theme: "Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 1 All You Ever Wanted to Know About U.S. Income Taxation of Business Enterprises Jack S. Levin."— Presentation transcript:

1 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 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

2 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 2 Table of contents Page no. _ I.What has shaped U.S. business tax system... 3 II.5 sources of U.S. business tax complexity III.A few examples of undue complexity IV.Govt failures and some possible solutions... 42

3 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 3 I. What has shaped U.S. business tax system Competing pressures: (a)Govt seeks to maximize revenue (b)Taxpayers seek to minimize payments (c)System should be, and should appear to be, fair (d)Govt 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

4 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 4 Conclusion Every specl provision to encourage/ discourage conduct creates a special rate, dedn, 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

5 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 5 II. 5 sources of U.S. business tax complexity 1.At least 5 different types of entities engage in business and they are subject to 3 very different tax regimes C corp S corp partnership LLC proprietorship

6 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 6 2.There are 2 principal sources of financing for business debt and equity (common and pfd stock) which are treated radically differently for tax purposes

7 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 7 3.There are 3 completely different merger/acqn 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 pship/LLC/proprietorship, and (2)on form of transaction (asset acqn or stock acqn)

8 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 8 4.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 dedns and a slew of different treatments for disfavored losses/dedns

9 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 9 Recurring pattern: Govt adopts tax incentive Then taxpayers squeeze conduct into favored category to use (or abuse) incentive Then govt adopts increasingly complex and lengthy rules to define favored category w/ more precision Govt also tends to split the baby by retaining tax incentive, but using AMT system to partially penalize those who claim incentive

10 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 10 5.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

11 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 11 III. A few examples of undue complexity

12 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 12 1.Five different types of business entities subjd to three different tax regimes* (a)C corp Subjd 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 distribn out of earnings and (ii)gain on sale of stock (including undistribd earnings which make stock more valuable) *Specl regimes for regulated investment companies (RICs) and real estate investment trusts (REITs) not herein discussed

13 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 13 (b)Pship/LLC/proprietorship Flow-thru taxation No entity-level tax Equity owner subjd to tax on share of entitys income (max 35% indivl rate) Entitys accumd income increases equity owners 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 pship or LLC taxed as C corp

14 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 14 (c)S corp Flow-thru taxation, similar (but not identical) to pship/LLC/ proprietorship But if entity is former C corp gain on asset sale subjd 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

15 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 15 Arbitrary and complex limitations on ability to use S No S corp S/H can be pship, 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)

16 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 16 (d)Addl rule Cant transform C or S corp into pship/LLC w/o triggering tax on all appreciation i.e., treat transformation to pship/ LLC as if all C or S corp assets sold at FV

17 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 17 2.Two principal sources of business capital treated radically differently (a)Debt financing Interest exp is dedble, providing shelter against corp-level tax Subj to 6 complex hurdles discussed in (e) below Result: single tax on debt holder

18 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 18 (b)Equity financing Dividends on common or pfd stock are not dedble 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

19 Tax Reform Panel © 3/05 Jack S. Levin 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

20 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 20 (d)When debt holder or equity holder is unrelated foreign person or TEO (e.g., ERISA plan, university endowment) (i)No tax on corps int payment No tax at corp level because int dedble, nor at debt holder level because TEO* (ii)Single tax on corps dividend payment Tax at corp level because dividend not dedble, but no tax on equity holder because TEO** *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)

21 Tax Reform Panel © 3/05 Jack S. Levin 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 govt 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

22 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 22 In particular, corp must overcome 6 complex interest dedn 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 subordd acqn debt w/ conversion or warrant feature

23 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 23 (iv)Code §163(j) (test #1) for debt held by > 50% S/H which is TEO or FP or pship/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/ substl int or prinl payable in, or by reference to, equity

24 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 24 (f)Above debt/equity distinctions are genly more important for corp than for pship/LLC/proprietorship

25 Tax Reform Panel © 3/05 Jack S. Levin 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 dedns, which genly exceed lessors rental income in early years, creating front-end tax losses and sheltering lessors 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

26 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 26 So govt (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

27 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 27 3.Mgrs and acqns (a)Theoretical underpining for tax-free orgzns and reorgs: Exchange of one property for another is taxable event, triggering appreciation But to facilitate business orgzns 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, govt responds w/ increasingly complex and lengthy rules

28 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 28 (b)§368 reorgzn rules Available only to C or S corp, not to pship/LLC/proprietorship 9 complex and arbitrary pigeon holes, which turn on formalities such as: (i) whether transaction is acqn of T stock, acqn of T assets, merger and (ii)whether BuyerCo acquires at parent or subsidiary level:

29 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 29 Two-party merger under §368(a)(1)(A) Forward subsidy merger under §368(a)(2)(D) Reverse subsidy merger under §368(a)(2)(E) Two-party stock-for-stock exchange under §368(a)(1)(B) Three-party subsidy stock-for-stock exchange under §368(a)(1)(B)

30 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 30 Two-party stock-for-asset exchange under §368(a)(1)(C) Three-party subsidy 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)

31 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 31 Each pigeon hole has combination of silly distinctions not contained in other pigeon holes: Whether substantially all of Ts assets must be acquired Permissibility of non-stock consideration Whether stock consideration must be voting stock Percentage of Ts stock that must be acquired

32 Tax Reform Panel © 3/05 Jack S. Levin 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

33 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 33 (ii)§721 pship/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 distribn is treated as occurring in connection with certain stock acqns

34 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 34 (d)Taxable acqn Tax result completely different than where transaction fits a tax-free acqn 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 pship/LLC/ proprietorship, BuyerCo takes asset SUB, w/ no double tax on sellers

35 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 35 (ii)Where T is C corp, (i) BuyerCo takes COB, w/ single tax on sellers, for stock acqn and (ii) SUB, w/ double tax on sellers, for asset acqn (iii)Where T is S corp, result turns on whether S corp was C corp at any time during past 10 yrs

36 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 36 4.Welter of tax rates and other specl treatments (a)Normal ordinary income top rate is 35% (for indivl 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 indivls gain on small business stock 15% for indivls capital gain* and qualified dividend income *Capital gain means long-term capital gain throughout this paper

37 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 37 32% (after several yr phase in) for U.S. net production income 36% for indivls comp income (inclg 1.45% medicare tax) 38% for indivls self employment income (inclg 2.9% medicare tax) Addl 20 points for indivls disqualified deferred comp Addl 20 points for indivls golden parachute comp

38 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 38 (c)As one example of complexity caused by specl tax break to encourage conduct, 10/04 legisn (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

39 Tax Reform Panel © 3/05 Jack S. Levin 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.

40 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 40 (ii)U.S. construction activities (iii)engineering or architectural services in U.S. for U.S. construction project

41 Tax Reform Panel © 3/05 Jack S. Levin 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

42 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 42 IV. Govt failures and some possible solutions (a)Failure of govt 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!!

43 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 43 E.g., C corp interest dedbility, but punctuated by 6 complex exceptions At least rationalize the 6 E.g., 9 complex pigeon holes defining tax-free reorgzns At least rationalize the 9

44 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 44 E.g., consider whether rate reduction for U.S. net production income and other specl rates, deductions, etc. worth signift 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

45 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 45 (b)Failure of govt to stick w/ decisions once made resulting in hundreds of law changes each yr (many not really necy), 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

46 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 46 (c)Govt efforts to make social policy through complex tax distinctions Golden parachute tax penalties for exec comp related to change in corp ownership inclg 20 points extra tax on exec and no corp dedn Limiting to $1m/yr public cos dedn 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

47 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 47 10/04 tax penalties for exec receiving deferred comp not w/in statutory pigeon holes inclg 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

48 Tax Reform Panel © 3/05 Jack S. Levin 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 necy and feels aggrieved Hundreds of changes each yr mean millions of taxpayers feel aggrieved each yr

49 Tax Reform Panel © 3/05 Jack S. Levin 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

50 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 50 (f)While tax complexity inevitable (because taxes inherently complex), much more govt effort necy to minimize (rather than geometrically multiply) complexity

51 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 51 Oral Presentation on 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

52 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 52 Overview I.What has shaped U.S. business tax system II.5 sources of U.S. business tax complexity III.A few examples of undue complexity IV.Govt failures and some possible solutions

53 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 53 I. What has shaped U.S. business tax system Competing pressures: (a)Govt seeks to maximize revenue (b)Taxpayers seek to minimize payments (c)System should be, and should appear to be, fair (d)Govt 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

54 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 54 Conclusion Every specl provision to encourage/ discourage conduct creates a special rate, dedn, 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

55 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 55 II. 5 sources of U.S. business tax complexity 1.At least 5 different types of entities engage in business and they are subject to 3 very different tax regimes C corp S corp partnership LLC proprietorship

56 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 56 2.There are 2 principal sources of financing for business debt and equity (common and pfd stock) which are treated radically differently for tax purposes 3.There are 3 completely different merger/acqn systems for taxing a combination of 2 business enterprises

57 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 57 4.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 dedns and a slew of different treatments for disfavored losses/dedns

58 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 58 Recurring pattern: Govt adopts tax incentive Then taxpayers squeeze conduct into favored category to use (or abuse) incentive Then govt adopts increasingly complex and lengthy rules to define favored category w/ more precision Govt also tends to split the baby by retaining tax incentive, but using AMT system to partially penalize those who claim incentive

59 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 59 5.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

60 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 60 III. A few examples of undue complexity

61 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 61 1.Five different types of business entities subjd to three different tax regimes (a)C corp Subjd 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 distribn out of earnings and (ii)gain on sale of stock (including undistribd earnings which make stock more valuable)

62 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 62 (b)Pship/LLC/proprietorship Flow-thru taxation No entity-level tax Equity owner subjd to tax on share of entitys income (max 35% indivl rate) Entitys accumd income increases equity owners basis in entity, so retained earnings not taxed on sale of entity No arbitrary limitations, as there are on S corp, but publicly traded pship or LLC taxed as C corp

63 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 63 (c)S corp Flow-thru taxation, similar (but not identical) to pship/LLC/ proprietorship But if entity is former C corp gain on asset sale subjd 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

64 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 64 Arbitrary and complex limitations on ability to use S No S corp S/H can be pship, 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)

65 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 65 (d)Addl rule Cant transform C or S corp into pship/LLC w/o triggering tax on all appreciation i.e., treat transformation to pship/ LLC as if all C or S corp assets sold at FV

66 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 66 2.Two principal sources of business capital treated radically differently (a)Debt financing Interest exp is dedble, providing shelter against corp-level tax Subj to 6 complex hurdles listed in appendix Result: single tax on debt holder

67 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 67 (b)Equity financing Dividends on common or pfd stock are not dedble 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

68 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 68 (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

69 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 69 (d)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 govt 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

70 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 70 3.Mgrs and acqns (a)Theoretical underpining for tax-free orgzns and reorgs: Exchange of one property for another is taxable event, triggering appreciation But to facilitate business orgzns 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, govt responds w/ increasingly complex and lengthy rules

71 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 71 (b)§368 reorgzn rules Available only to C or S corp, not to pship/LLC/proprietorship 9 complex and arbitrary pigeon holes listed in appendix, which turn on formalities such as (i) whether the transaction is acqn of target entity (T) stock, acqn of T assets, merger and (ii) whether BuyerCo acquires at parent or subsidiary level

72 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 72 Each pigeon hole has combination of silly distinctions not contained in other pigeon holes: Whether substantially all of Ts assets must be acquired Permissibility of non-stock consideration Whether stock consideration must be voting stock Percentage of Ts stock that must be acquired

73 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 73 (c)Rules for tax-free contribution of assets to, and distribution of assets by, business entities also enormously complex and differ depending on the nature of assets and type of business entity

74 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 74 (d)Taxable acqn Tax result completely different than where transaction fits a tax-free acqn pigeon hole As described in appendix, tax result varies greatly depending on whether T is C corp, S corp or pship/LLC and whether BuyerCo acquires T stock or T assets

75 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 75 4.Welter of tax rates and other specl treatments (a)Normal ordinary income top rate is 35% (for indivl 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 indivls gain on small business stock 15% for indivls capital gain and qualified dividend income

76 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 76 32% (after several yr phase in) for U.S. net production income 36% for indivls comp income (inclg 1.45% medicare tax) 38% for indivls self employment income (inclg 2.9% medicare tax) Addl 20 points for indivls disqualified deferred comp Addl 20 points for indivls golden parachute comp

77 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 77 One example of tax break to encourage conduct is new reduced tax rate (phasing down to 32%) on U.S. net production income Rate reduction covers net income from activities including sale of: (i)tangible personal prop'y, computer software, or sound recording mfd, produced, grown, or extracted by taxpayer w/in U.S. (ii)motion picture film or tape produced by taxpayer in U.S., w/ no "actual sexually explicit conduct"

78 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 78 Creates tremendous acctg/admin/audit complexity: Need to calculate net income from covered activity, i.e., allocating receipts and exps betw covered (U.S. production) and non- covered activities (U.S. retail, wholesale, service, and transportation income and foreign production)

79 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 79 IV. Govt failures and some possible solutions (a)Failure of govt to make hard decisions resulting in multitude of rules, definitions, exceptions, qualifications, and sub- categories, rather than one (or few) rules 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!!

80 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 80 C corp interest dedbility, but punctuated by 6 complex exceptions At least rationalize the 6 exceptions 9 complex pigeon holes defining tax- free reorgzns At least rationalize the 9 pigeon holes

81 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 81 Consider whether rate reduction for U.S. net production income and other specl rates, deductions, etc. worth signift 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 Consider whether, given availability of LLC form, the separate S corp tax regime is worth the added complexity Consider whether all business entities should be governed by a unified single-tax regime

82 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 82 (b)Failure of govt to stick w/ decisions once made resulting in hundreds of law changes each yr (many not really necy), i.e., churning the tax law Sunsets for Bush tax reductions On again, off again R&D credits and bonus depreciation

83 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 83 (c)Govt efforts to make social policy through complex tax distinctions Golden parachute tax penalties for exec comp related to change in corp ownership Limiting to $1m/yr public cos dedn 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

84 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 84 10/04 tax penalties for exec receiving deferred comp not w/in statutory pigeon holes Denying rate reduction for U.S. net production income for sexually explicit movie making IRS auditors arbiters of sexually explicit

85 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 85 (d)Complexity, unfairness, and churning breed contempt for tax law Taxpayer disadvantaged by tax-law change questions why change necy and feels aggrieved Hundreds of changes each yr mean millions of taxpayers feel aggrieved each yr

86 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 86 (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 (f)While tax complexity inevitable (because taxes inherently complex), much more govt effort necy to minimize (rather than geometrically multiply) complexity

87 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 87 Appendix

88 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 88 1.Additional notes on debt-equity distinction (a)When debt holder or equity holder is unrelated foreign person or TEO (e.g., ERISA plan, university endowment) (i)No tax on corps int payment No tax at corp level because int dedble, nor at debt holder level because TEO* (ii)Single tax on corps dividend payment Tax at corp level because dividend not dedble, but no tax on equity holder because TEO** *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)

89 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 89 (b)6 complex interest dedn hurdles for corps: (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 subordd acqn debt w/ conversion or warrant feature

90 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 90 (iv)Code §163(j) (test #1) for debt held by > 50% S/H which is TEO or FP or pship/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/ substl int or prinl payable in, or by reference to, equity

91 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 91 (c)Debt/equity distinctions are genly more important for corp than for pship/LLC/proprietorship

92 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 92 2.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 dedns, which genly exceed lessors rental income in early years, creating front-end tax losses and sheltering lessors 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

93 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 93 So govt (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

94 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 94 3.Reorganization pigeon holes Two-party merger under §368(a)(1)(A) Forward subsidy merger under §368(a)(2)(D) Reverse subsidy merger under §368(a)(2)(E) Two-party stock-for-stock exchange under §368(a)(1)(B) Three-party subsidy stock-for-stock exchange under §368(a)(1)(B) Two-party stock-for-asset exchange under §368(a)(1)(C) Three-party subsidy 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)

95 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 95 4.Tax-free contributions and distributions (a)§351 corporate formation rules Tax triggered if control test flunked, if corp is an investment company, or if excessive liabilities are assumed (b)§721 pship/LLC formation rules Tax triggered if treated as disguised sale (c)§355 spin-offs Tax triggered if flunk control, business purpose, active business, device, or other tests or if distribn is treated as occurring in connection with certain stock acqns

96 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP 96 5.Taxable acquisitions (a)Where T is pship/LLC/ proprietorship, BuyerCo takes asset SUB, w/ no double tax on sellers (b) Where T is C corp, (i) BuyerCo takes COB, w/ single tax on sellers, for stock acqn and (ii) SUB, w/ double tax on sellers, for asset acqn (c) Where T is S corp, result turns on whether S corp was C corp at any time during past 10 yrs


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