All You Ever Wanted to Know About U. S 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Table of contents Page 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

volumes of new regulations and definitions 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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 C corp S corp partnership LLC proprietorship Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

and these 3 systems reach very different results depending on: 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) Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

and a slew of different treatments for favored ded’ns 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

Regular income tax rules at rates up to 35% 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

Subj’d to double taxation: (1) Corp-level tax (max 35% corp rate) on: 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) * Spec’l regimes for regulated investment companies (RICs) and real estate investment trusts (REITs) not herein discussed Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

But if entity is former C corp (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

Interest exp is ded’ble, providing shelter against corp-level tax 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Dividends on common or pfd stock are not ded’ble at corp-level (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

(i) No tax on corp’s int payment (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** * 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) Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Because debt is liability, interest yield is expense (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

(f) Above debt/equity distinctions are gen’ly more important for corp than for p’ship/LLC/proprietorship Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

AMT slower depreciation 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

(a) Theoretical underpining for tax-free org’z’ns and reorgs: 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Available only to C or S corp, not to p’ship/LLC/proprietorship (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: Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

Whether substantially all of T’s assets must be acquired 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

(i) §351 corporate formation rules (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

Tax result varies greatly depending on form of target entity (T) (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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 * Capital gain means long-term capital gain throughout this paper Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

35% rate phases down to 32% over several yrs (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

E.g., exec comp, hdqrs overhead, R&D 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

At least rationalize the 6 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

E. g. , consider whether rate reduction for U. S 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

incl’g 20 points extra tax on exec and no corp ded’n (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

incl’g 20 points extra tax on exec 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

(f) While tax complexity inevitable (because taxes inherently complex), much more gov’t effort nec’y to minimize (rather than geometrically multiply) complexity Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

Overview What has shaped U.S. business tax system 5 sources of U.S. business tax complexity A few examples of undue complexity Gov’t failures and some possible solutions Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

volumes of new regulations and definitions 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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 C corp S corp partnership LLC proprietorship Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

and a slew of different treatments for favored ded’ns 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

Regular income tax rules at rates up to 35% 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

Subj’d to double taxation: (1) Corp-level tax (max 35% corp rate) on: 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) Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

(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, but publicly traded p’ship or LLC taxed as C corp Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

But if entity is former C corp (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

Interest exp is ded’ble, providing shelter against corp-level tax 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 listed in appendix Result: single tax on debt holder Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Dividends on common or pfd stock are not ded’ble at corp-level (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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

Because debt is liability, interest yield is expense (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 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

(a) Theoretical underpining for tax-free org’z’ns and reorgs: 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Available only to C or S corp, not to p’ship/LLC/proprietorship (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 listed in appendix, which turn on formalities such as (i) whether the transaction is acq’n of target entity (T) stock, acq’n of T assets, merger and (ii) whether BuyerCo acquires at parent or subsidiary level Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Whether substantially all of T’s assets must be acquired 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

and whether BuyerCo acquires T stock or T assets (d) Taxable acq’n Tax result completely different than where transaction fits a tax-free acq’n pigeon hole As described in appendix, tax result varies greatly depending on whether T is C corp, S corp or p’ship/LLC and whether BuyerCo acquires T stock or T assets Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

Rate reduction covers net income from activities including sale of: 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" Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

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

Consider whether rate reduction for U. S 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 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

(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 Sunsets for Bush tax reductions On again, off again R&D credits and bonus depreciation Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Limiting to $1m/yr public co’s ded’n for comp to each of 5 top execs (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 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

making IRS auditors arbiters of sexually explicit 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

(d) Complexity, unfairness, and churning breed contempt for tax law 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

(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 gov’t effort nec’y to minimize (rather than geometrically multiply) complexity Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

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

(b) 6 complex interest ded’n 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 subord’d acq’n debt w/ conversion or warrant feature Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

(c) Debt/equity distinctions are gen’ly more important for corp than for p’ship/LLC/proprietorship Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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

AMT slower depreciation 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 Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Reorganization pigeon holes 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) 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) Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

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 p’ship/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 distrib’n is treated as occurring in connection with certain stock acq’ns Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP

Taxable acquisitions (a) Where T is p’ship/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 acq’n and (ii) SUB, w/ double tax on sellers, for asset acq’n (c) Where T is S corp, result turns on whether S corp was C corp at any time during past 10 yrs Tax Reform Panel © 3/05 Jack S. Levin KIRKLAND & ELLIS LLP