1. 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

2. Table of contents Page no._
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

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

4. 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. 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

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

7. 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

8. 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

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

10. 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

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

12. 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

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

14. 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

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

17. 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

18. 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

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

20. (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

21. 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

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
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 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

24. (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

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

26. 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

27. (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

28. 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

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)
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 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

31. 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

32. (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

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

34. 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

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

36. 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

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

38. 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

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

41. 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

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

43. 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

44. 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

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

46. 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

47. 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

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

52. 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

53. 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

54. 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

55. 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

56. 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

57. 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

58. 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

59. 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

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

61. 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

62. (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

63. 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

64. 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

65. (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

66. 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

67. 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

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

69. 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

70. (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

71. 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

72. 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

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

74. 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

75. 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

76. 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

77. 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

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

79. 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

80. 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

81. 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

82. (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

83. 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

84. 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

85. (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

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

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

88. 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

89. (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

90. (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

91. (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

92. 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

93. 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

94. 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

95. 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

96. 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