Should corporations pay tax?

Fiscal policy shoots the middle class. Monetary policy also shoots the middle class. What a coincidence.
Actually, it's no coincidence at all.

 

It is really not that murky; you pay tax on dividend or distribution from the Corp to the shareholder; it is deducted by the Corp from the dividend or distribution at the time it is paid. That is very simple and it follows the basic tax maxim of levying the tax when the money is paid.

Where the Corp retains earnings and does not pay a dividend or distribute earnings the tax is deferred. This allows efficient reinvestment of profit, pre-tax, back into the enterprise in order to increase productivity and grow the business without total reliance on debt financing.

To avoid abuse of Corps never paying a dividend or distribution of earnings, you require the Corp to justify the retention of earnings for a business purpose or investment, acquisition or payment of debt; not share buy backs. You also put a ceiling on how much debt a corporation is allowed to expense; so that excess leverage is not deductible.

Understand that capital investment of retained profit into the business or in the acquisition of another business creates taxable events in and of itself.

Clearly, this approach is not going to be favored by the finance industry which has made massive profits by leveraging corporate cash flows; this type of policy would discourage that kind of leveraging.

 

The "require the Corp to justify the retention of earnings for a business purpose" part is the murky part. Who decides if it's a justifiable business purpose? A govt employee with no background in the complex niche where my company operates? As both a former govt employee and an entrepreneur I can tell you this is simply unworkable, however good it sounds in theory.

 

Like all IRS regulations it will interpreted by statute, clarifying regulation, published rulings, practice and court decisions. This regulation has been in effect for decades and there is a case history in how it has be applied and interpreted over time.

 

4.10.13.2 (03-16-2015)
Accumulated Earnings Tax (IRC 531)

1. The purpose of the accumulated earnings tax is to prevent a corporation from accumulating its earnings and profits beyond the reasonable needs of the business for the purpose of avoiding income taxes on its stockholders.
   
   
2. Liability for the accumulated earnings tax is based on the following two conditions:
   
   1. The corporation must have retained more earnings and profits than it can justify for the reasonable needs of the business
      
      
   2. There must be an intent on the part of the corporation to avoid the income tax on its stockholders by accumulating earnings and profits instead of distributing them
      
3. Any corporation within a chain of corporations can be subject to the accumulated earnings tax. A subsidiary corporation can be subject to the accumulated earnings tax even though the parent corporation is not subject to the accumulated earnings tax and vice versa.
   
   
4. The accumulated earnings tax is computed on the corporation's accumulated taxable income for the taxable year or years in question.
   
   
5. The accumulated taxable income is the corporation's taxable income with various adjustments. These adjustments are made primarily for the purpose of arriving at an amount that corresponds more closely to financial reality and thus, measures more accurately the corporation's dividend paying capacity for the year.
   
   
6. The term "earnings and profits" is not defined in any of the revenue acts. The amount of earnings and profits for a taxable year usually is computed by adjusting taxable income in accordance with CFR 26 CFR 1.312-6.
   

4.10.13.2.1 (03-16-2015)
Considerations in Computing Accumulated Earnings and Profits

1. In order for the examiner to make a determination of the corporation's accumulated earnings and profits, the following items should be considered:
   
   1. Book "earned surplus" should be analyzed. The book account may have been reduced by the transfers to capital, or other accounts, in the form of stock dividends or reserves.
      
      
   2. Some accounting write-offs of surplus might not qualify as write-downs of earnings and profits for tax purposes.
      
      
   3. It is generally helpful to reconcile the surplus shown in the books to earnings and profits available for tax purposes.
      
      
   4. Life insurance proceeds are a part of earnings and profits and are available for dividend distribution.
      
      
   5. Excess of percentage depletion over cost depletion constitutes a part of earnings and profits.
      
      
   6. At some time during the history of the corporation, surplus may have been reduced by writing down purchased goodwill or other intangible assets. For this reason, the examiner should prepare a careful analysis of the earned surplus account for the year under examination and at least the five preceding years, and the amount and date of any cash dividends paid shortly after the close of the year under examination. If any distribution of dividends in reorganization was made, full details of such distribution should be stated.
      

4.10.13.2.2 (03-16-2015)
Indicators of Intent

1. A prerequisite to imposition of the IRC 531 tax has been that the corporation be formed or availed of for the purpose of avoiding the income tax on its shareholders. As purpose involves a state of mind or intent, it is necessary to look at the surrounding facts and circumstances in each individual case to determine whether the purpose of the accumulated earnings was to allow the shareholders to avoid the income tax or for some other purpose.
   
   
2. The following factors should be considered in determining whether the tax avoidance purpose was present:
   
   1. Dealings between the corporation and its shareholders, including loans to shareholders and expenditures of corporate funds for the personal benefit of the shareholders:
      
      • Corporate loans to or expenditures on behalf of shareholders tend to show that the corporation has the capacity to distribute these funds as dividends, particularly if there is a pattern of these transactions
        
        
      • The loans or expenditures are substitutes for dividends and show that corporate earnings are diverted
        
        
      • The examiner should include an analysis of amounts, if any, withdrawn by the stockholders in the form of loans or advances and reflected in the asset accounts at the close of the year under examination
        
   2. Investments of undistributed earnings in assets having no reasonable connection with the corporation's business:
      
      • An inference may arise if the corporation has invested its funds for purposes which are not reasonably related to the business
        
        
      • Such unrelated investments evidence the liquidity and dividend-paying capacity of the corporation, as well as an inference that the failure to distribute such funds as dividends was for the purpose of avoiding shareholder taxes
        
   3. The corporation's dividend history:
      
      • A failure to distribute dividends or minimal payments indicates that earnings may have been accumulated to avoid shareholder taxes
        
        
      • The examiner should include a statement showing the amount of taxes actually avoided by the principal stockholders through the failure of the corporation to distribute all of its earnings for the year under consideration
        
        
      • Even if the corporation has a good dividend record and pays liberal officer-stockholder salaries, this does not in itself serve to rebut the tax avoidance factor
        
3. IRM 4.8.8.2(1), Accumulated Earnings Tax, discusses that the burden of proof is on the Commissioner unless a notification is sent to the taxpayer under IRC 534 (b), Burden of Proof, prior to the issuance of a notice of deficiency. Letter 572, Proposal to Issue a Notice of Deficiency for Excess Accumulated Earnings Under IRC Section 531 is used for this notification. see Exhibit 4.10.13-3
   
   
4. IRM 4.8.8.2(2) notes the following important points:
   
   1. The notification Letter 572 may be sent to the taxpayer prior to issuance of the 30-day letter or concurrently with the 30-day letter (in which case the purge date will allow for 60 days rather than the normal 30 days).
      
      
   2. The letter must be sent by certified mail, normally by the examiner using the examiner’s contact information.
      
      
   3. Only officials and Technical Services’ reviewers delegated to sign notices of deficiency pursuant to Servicewide Delegation Order 4-8 are authorized to sign notifications under IRC 534 (b) according to Rev. Proc. 56-11, 1956-1 C.B. 1028.
      
      
   4. Each case is forwarded to Technical Services to sign Letter 572. Technical Services will return the case to the group for certified mailing and suspense.
      

 

My opinion certainly, but there are easy things to clarify by regulation, rulings... and hard things. "justifying earnings for a business purpose" is one of the hard to nearly impossible things to draw a bright line test for or even a squishy definition that can be fairly applied across the myriad of businesses in the country. For me this falls into a similar category of squishiness as "reasonable salary" test for C-corps. If you own 100% of your own C-corp, you're best off from a tax perspective to pay all the profits to yourself as salary. To prevent this the IRS has a rule that you can only pay officers of a C-corp a "reasonable" salary (IRC § 162(a)(1)). In practice, small companies that can't afford to fight a protracted legal battle with the IRS are almost completely arbitrarily hit by it at the whim of whoever is auditing returns, while in "Menard Inc. v. Commissioner" the IRS lost a case against paying the CEO of Menard's over $20M in salary because you can almost always find a case where someone somewhere in a somewhat related industry is getting paid as much as you pay yourself if you have good enough attorneys.
That's just a start, let's talk about how much it kills entrepreneurial businesses to require them to justify to the IRS what they retain every year, especially if they're in a disruptive industry where there are no precedents and it's very possible no-one at the IRS has even the faintest understanding of what they're doing or let alone much cash they'd need to do it and in fact no-one really knows because it's all new. As a former federal employee I'd absolutely hate being in the position to have to make decisions like that, and as an entrepreneur it would kill innovation (and investment) for me and my fellow entrepreneurs to have to deal with this kind of burden. It really falls into the great idea in theory, horrible unintended consequences in practice bucket, again IMHO having sat on both sides of the table with this kind of thing.

 

We are talking about the issue of Corporate Taxes and my opinion that the tax rate should be reduced to Zero at the corporate level and raised to the individual rates at the dividend distribution level; a detail of that proposal is that there must be some way to prevent abuse by not paying dividends.

The immediate criticism is that this is too "murky," "kills entrepreneurial business," and has "horrible unintended consequences." I think that criticism simply collapses when you realize that we already have that in the current code and this proposal would make that much more simple. The provision against accumulated earnings is already in the code; it has been there for years; it is not a new proposal.

I agree the compensation issue is problematic; I would point out that in the Scorp context the compensation issue is always the opposite of the Ccorp dilemma; "are you paying the active owner enough for the work done?"...to avoid employment taxes, but we are not really talking about compensation regulation now, that is not a central corporate tax issue.

 

I only bring comp up as an example of how impossible it is to do something "squishy" in taxes. I see your idea to switch (regardless of if it is current code it's a switch from current practice) as a similar "squishy" idea with similar consequences. Didn't mean to bring up the comp rules as something that need to be changed, obviously the point would be moot if we went with your idea, which is one mark for it, as well as the simplicity as you point out.
Great discussion though, clearly a lot of different thoughts on this and it's hard to know how any of them would pan out until they actually were put into practice.

 

There absolutely must be clear rules.

If the IRS harrassing tea party tax exempts for having the wrong political persuasion hasn't yet convinced you of that, more than likely nothing will.

Give IRS agents the ability to 'decide' whether you've distributed enough earnings, and they'll decide alright.

 

Guess you never been audited? Most people are just like traders, lazy. If you come very prepared like war, have documents last ten years at your fingertips at the audit, the agent is impressed he doesn't have to wait while you fumble around looking for a miracle, otherwise if you allow those &^#^$% agents ability to decide, you going to get screwed. Best to have set rules and be able to show each year you abiding by set rules. That is what the government wants, they want you to be a robot, eventually we be like Charles Heston yelling "Soylent Green".