in excess of new equity capital is intended to be consistent with the first proposal in treating new equity and debt similarly.

The Reporter's third proposal would distinguish between a corporate shareholder's portfolio and direct investments. Any investment in a majority of the common stock of an issuer for a year would be a direct investment; any investment in 10 percent or more of the common stock of an issuer could electively be designated as a direct investment; other investments would be portfolio investments. The proposal would deny a corporate shareholder deductions for dividends received on portfolio investment. Payment for the corporate acquisition of any direct investment (which could still qualify for the deduction) would be treated as a nondividend distribution subject to the excise tax imposed by the second proposal. The proposal notes that such acquisitions could have an effect comparable to redemptions, i.e., the distribution of corporate earnings outside of a corporation without being taxed as dividends. 23 The proposal would also deny a corporate shareholder deductions for dividends received on a direct investment until the time at which the dividends were redistributed.

Modification of the dividends received deduction

Whether or not a dividends paid deduction is implemented, certain modifications to the dividends received deduction (other than those contained in the Administration proposal) could be made. The most extreme option would be the elimination of the deduction (subject to appropriate transition rules). A somewhat less extreme option (as proposed by in the Reporter's Study Appendix to the ALI Subchapter C Proposals) would be elimination of the deduction for portfolio investment. Another option would be limiting the dividends received deduction to dividends that are paid out of earnings that have been subject to corporate tax. Others have suggested allowing the deduction for the lesser of dividends received or paid by the corporation during the year.24

Some have suggested requiring a recipient corporation to reduce its basis in the stock of a distributing corporation by the amount of dividends excluded from the recipient's income because of the dividends received deduction, or possibly requiring reduction of such basis only for purposes of determining losses on the ultimate sale of the stock, at least in some circumstances beyond those covered by section 1059.

In general

Analysis

Considerable disagreement exists about the role of the corporate income tax in the U.S. tax system. Many favor the treatment of

23 The Reporter's proposal notes that this could occur since assets (in the form of the payment made by the acquiring corporation to the other corporation's shareholders) are removed from corporate solution (of the acquiring corporation) and placed in the hands of the selling shareholders, while the acquiring corporation (unlike the selling shareholders) would be entitled to a dividends received deduction for distributions from the acquired company.

24 A similar but somewhat more complex cpproach was discussed by the Treasury in 1983 Testimony. See Testimony of Ronald A. Pearlman, Deputy Assistant Secretary (Tax Policy), Department of the Treasury, in "Reform of Corporate Taxation," Hearings before the Committee on Finance, United States Senate, 98th Cong., 1st Sess. (October 24, 1983), at pp. 38-40.

corporations as entities separate from their shareholders along with the imposition of separate unintegrated taxes on income earned by corporations and on dividends distributed to shareholders. Others, however, contend that the separate taxation of corporations and their shareholders has undesirable economic effects that should be alleviated by providing some relief from the two-tier tax.

Revenue considerations, perception of the corporate entity, and speculation about the economic effects of a separate corporate level tax, including "who pays the tax" and what economic decisions may be influenced by the existence of the tax, all play a role in the debate on this issue.

Arguments in favor of two-tier tax

Advocates of the two-tier tax generally argue that the corporate tax not only is a source of revenue that might not easily be replaced if the corporate tax were eliminated either directly or indirectly, but also is a tax imposed on an appropriate income base. Imposing a separate corporate income tax is supported by those who view corporations as vehicles for accumulating capital that are entities distinct from the individuals who contributed the capital and who enjoy limited liability with respect to the corporation's obligations and activities.

In many cases, corporations are viewed as not being effectively controlled by shareholders but rather by the corporate officers and directors. It is argued that it is appropriate to treat the earnings on accumulations of capital in such circumstances as a proper base of taxation.25 In contrast, certain corporations that may be considered as directly controlled by shareholders are permitted to elect treatment under subchapter S, which permits the S corporation to avoid being taxed as a separate entity.2

26

Another argument for the imposition of a separate corporate tax is that it is a necessary "backstop" to the individual income tax in the case of retained earnings. Without either a deemed distribution system analogous to the S corporation model or a substantial corporate tax, income could be accumulated without bearing adequate income tax compared to the amount of tax that would be paid if the income were earned directly by individuals.

For example, if there were either no corporate tax or a corporate tax imposed at a much lower rate than the individual tax, individuals would be able to invest assets in corporations where these assets would earn and accumulate income that was not taxed currently (or only taxed at low rates currently). Such income earned by corporations, to the extent reflected in increased value would be taxed on a deferred basis to the individuals, perhaps at capital gains rates or perhaps not at all in the case of an individual who holds appreciated shares of stock at death (sec. 1014). Thus, some

25 See Richard Goode, The Corporation Income Tax (Wiley, 1951), pp. 24-43; Joseph A. Pechman, Federal Tax Policy (Brookings Inst., 4th ed, 1983), p. 130.

26 Extension of the S corporation model of taxation to other corporations could be viewed as imposing current tax on shareholders with respect to income the distribution of which they do not effectively control. The burden of such an approach could be alleviated if the tax is collected for the shareholders out of corporate funds, as a withholding tax, but differences in the effective rates of shareholders could involve complexity.

contend that absent full integration, the imposition of a substantial corporate tax on undistributed corporate earnings is at a minimum justified in order to prevent deferral or complete avoidance of taxation of the income earned through corporations.27

Any need for a current corporate tax approximating individual rates on accumulated earnings in order to "backstop" the individual tax and compensate for deferral of individual tax is not, however, necessarily undermined by the granting of relief from the corporate tax on distributed income since the distributed income generally would be taxable immediately to the recipient shareholders, thereby ending any deferral. Some opponents of relief from the two-tier tax may nevertheless contend that the separate tax should be retained without relief even on distribution of earnings, to compensate adequately for deferral that may occur to the extent that an individual's effective rate may exceed a corporation's effective rate. Some also contend that given the distribution of ownership of corporate equity, the two-tier tax adds to the progressivity of the income tax system, and that relief from the two-tier tax would disproportionately benefit wealthy taxpayers.

In addition, some have argued that a two-tier tax system is an appropriate method of preventing tax evasion and shelter activity and otherwise promoting compliance. For example, it has been suggested that tax evasion and tax shelter activity with respect to any particular tax may be greater with higher marginal rates. This observation has led to the suggestion that a two-tier tax with lower rates at each tier rather than a higher-rate single-tier tax is preferable from the standpoint of compliance and avoiding incentives to shelter income.28

It has also been argued that countries that have adopted some form of relief from the two-tier tax have done so for reasons unrelated to any theoretical preference for a "conduit" view of the corporation and individual income taxes, e.g., France to stimulate its capital markets and Canada to promote domestic ownership of industry.29

Arguments for relief from the two-tier tax

Advocates of relief contend that the relationship of the separate corporate and individual income taxes tends to create certain distortions in economic decisions that should be alleviated by providing some form of relief from the two-tier tax.30 Such advocates generally contend that the tax system should seek to provide (a) neutrality between corporate and noncorporate investment, (b) neutrality between debt and equity financing at the corporate level, and (c) neutrality between retention and distribution of corporate earnings.

One concern that has been expressed is that the two-tier tax may discourage some from deciding to carry on business in corporate

27 See Pechman, n. 25, supra.

28 See Marks, "Tax Income Again and Again," Wall Street Journal, June 24, 1985, p. 18. 29 See Surrey, "Reflections on 'Integration' of Corporation and Individual Income Taxes," 28 National Tax Journal 335, 335 n.2 (Sept. 1975).

30 For discussion with analysis of the various possible effects of the two-tier tax, see, e.g., Warren, "The Relation and Integration of Individual and Corporate Income Taxes," 94 Harv. L. Rev. 719, 721-738 (1981).

form in situations where nontax considerations indicate that corporate operations would be preferable. The extent to which this may occur depends in large part upon where the corporate tax ultimately falls. As discussed below, there are differing views of the extent to which the burden of the corporate tax is in fact borne by shareholders rather than "passed on" to consumers or employees of corporations. A related concern is that to the extent alternative forms of operation are available that offer some of the advantages of a corporation without the burden of corporate tax (such as a limited partnership), taxpayers effectively can elect whether or not to subject themselves to the corporate tax in any event.31

Another concern is that the two-tier tax in its present form may encourage financing corporate investment with debt rather than new equity, because deductible interest payments on corporate debt reduce corporate taxes while nondeductible dividends do not.

For example, if an individual in the 50 percent marginal tax bracket invests $1,000 in a corporation as equity, and the corporation, subject to a 46 percent tax rate, earns a 10 percent ($100) pretax return, there will be only $54 available after corporate tax for distribution and the individual will have only $27 left after individual taxes on this distribution. The total tax on the $100 of earnings is $73 (73 percent). However, if the individual lends $1,000 to the corporation at 10 percent interest, the corporation can deduct the full $100 interest payment so that no corporate tax is paid, while the $100 distribution is subject to a $50 (50 percent) tax in the hands of the individual (the same tax that would have been paid if the $100 were earned outside of corporate solution). Therefore, corporate earnings distributed as dividends are subject to an additional 23 percent tax not borne by earnings distributed as interest.

Accordingly, there may be a incentive for an individual to structure an investment using a large amount of debt rather than equity. Similarly, from the point of view of the corporation and its existing shareholders, new equity from individuals is more costly than debt because greater pre-tax earnings are needed to provide the same market return to the new investor.

On the other hand, the corporate dividends received deduction (which is 85 percent for portfolio investment and can be 100 percent for direct investment) provides an incentive for a corporation to invest in stock rather than debt of another corporation. Furthermore, when an issuing corporation has tax losses so that the interest deduction provides no additional tax benefit, it may be able to issue to corporations preferred stock that mimics debt-for example, providing a floating dividend rate pegged to Treasury bill interest rates-effectively passing through some of the benefit of its losses to corporate shareholders.32 It is not clear to what extent taxable corporations may respond to tax incentives to issue debt, while corporations that are unable to benefit from an interest deduction because of other tax losses may prefer to issue stock to corporate investors.

31 See the discussion of entity classification in Part V., below. For example, a profitable corporation that desires to distribute most of its earnings currently may seek to operate in limited partnership form to eliminate the corporate tax on such earnings.

32 See discussion under "Treatment of intercorporate distributions-the dividends received deduction", infra.

To the extent that a two-tier tax results in a bias in favor of debt financing, the risk of bankruptcy is increased for corporations, particularly those in cyclical industries. Moreover, the importance of the distinction between debt and equity, both for individual investors and corporate issuers that would prefer investments to be characterized as debt, and for corporate investors and issuers that would prefer investments to be characterized as equity, also generates difficult legal problems in distinguishing between the two.33 A further issue is whether the two-tier tax distorts decisions to retain or to distribute corporate earnings. Where shareholders are better able than their corporation to put capital to its most productive use, then a tax-based disincentive to distribute earnings creates an economic inefficiency. Conversely, where a corporation is better able to invest capital than its shareholders, any incentive to distribute earnings also creates an inefficiency. Where the corporation and its shareholders are both able to make the best possible investments, no inefficiency necessarily would result from incentives to retain or distribute earnings. Advocates of relief from the two-tier tax contend that the present system is not neutral with respect to the distribution or retention of earnings, and that increased neutrality is desirable.

The two-tier tax on dividend distributions can make it more desirable for a corporation to use retained earnings, rather than new equity from individuals for its investments. Shareholders can find such earnings retention attractive (subject to the accumulated earnings tax and personal holding company rules) where the shareholder expects to realize the value of such reinvested earnings at preferential capital gains rates on an ultimate redemption or sale of the stock or liquidation of the corporation 34 or intends to hold stock until death, so that appreciation can be passed to his heirs free of individual income tax (sec. 1014).

There is also an incentive under present law to retain earnings if the corporation's current effective tax rate on undistributed earnings is lower than the shareholder's current effective rate on distributed earnings. 35

On the other hand, where the effective tax rate of the shareholder is significantly lower than the corporate effective tax rate-for example, if the shareholder is a tax-exempt entity or is a corporation entitled to a dividends received deduction-there may be an incentive to distribute earnings.

33 Illustrative of the difficulties inherent in distinguishing debt from equity is the fact that in 1969, Congress authorized the Treasury Department to issue such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or debt (sec. 385). In the approximately 16 years since that time, the Treasury has issued and withdrawn several sets of proposed regulations, none of which has ever become effective.

34 In liquidation, unrealized appreciation in corporate assets may remain untaxed at the corporate level while the shareholder obtains a stepped-up basis at the price of a capital gains tax only. See discussion in Part III., below. Advocates of relief from the two-tier tax also point out that the advantage of capital gains treatment for individual shareholders, and of dividend treatment for corporate shareholders, generates difficult legal issues in an attempt to determine whether a particular redemption or other distribution out of corporate solution should be treated as an ordinary income "dividend" or a capital gain "sale" transaction.

35 Under present law, the top marginal ordinary income tax rate is 50 percent for individuals and 46 percent for corporations. The Administration proposes a top marginal ordinary income tax rate of 35 percent for individuals and 33 percent for corporations. The actual effective rates for a particular corporation or individual of course may vary further, depending, for example, on the availability of tax preferences or other deductions.