The arguments that the complete repeal of General Utilities would have some undesirable collateral effects on capital formation and the economy or would discourage use of the corporate entity are, they contend, largely unsubstantiated, as are arguments that small businesses would suffer most from repeal. Any potential inequities resulting from repeal could be addressed by providing liberal transition relief and phase-in rules. If Congress wishes to encourage small business or promote other social policies, these critics argue, there are better alternatives than using the tax Code. (Even within the tax Code, they contend, there are better, more direct alternatives such as further reductions in the graduated rate schedules.) If an unintegrated, two-tier system of taxation is deemed to be too harsh, Congress should provide relief in the form of full or partial integration on a nondiscriminatory basis.

Impact of repeal on other provisions of Code

Repeal of the General Utilities rule may create additional pressure for taxpayers to bring acquisition and liquidation transactions within the tax-free reorganization provisions of the Code. Furthermore, investors and entrepreneurs may resort to partnerships or other pass-through entities as vehicles for carrying on business. If this occurs, additional strain may be placed on the provisions of the Code relating to reorganizations, classification of entities, and taxation of pass-through entities. Congress may find it necessary to reexamine these provisions to assure that they are operating rationally and efficiently, and do not present opportunities for tax avoid

ance.

Alternatives to complete repeal

If Congress decides that a complete repeal of the General Utilities rule is unwarranted, it may wish to consider eliminating the nonrecognition treatment under section 336 for all liquidating dispositions of ordinary income assets, and repealing the remaining exceptions to recognition under section 311. In the hearings conducted by the Senate Finance Committee in 1983,1 101 none of the witnesses advocated permanent relief for dispositions of assets outside a liquidation context. Furthermore, it has been contended that there is no logical basis for exempting inventory, whether or not sold in bulk, or other assets held for sale to customers in the ordinary course of business. Congress might also consider amendments to section 337 that would make "straddles" of that provision-that is, selective recognition of losses on depreciated assets without recognition of gain on appreciated assets-more difficult.

A more limited solution to the General Utilities problem would be to tighten the recapture provisions of the Code. For example, section 1250 could be modified to require that upon disposition of section 1250 property, an amount equal to the excess of depreciation claimed over the economic decline in value must be recognized as ordinary income to the transferor even if depreciation has been taken on a straight-line basis. This would conform the rules for depreciable real property with those for depreciable personal proper

101 "Reform of Corporate Taxation," Hearing before the Committee on Finance, United States Senate, 98th Cong., 1st Sess. (October 24, 1983).

Continued

ty (sec. 1245).102 In addition, gain on all mineral property could be included in income to the extent of previously deducted intangible drilling costs, regardless of whether deducted before or after 1976, or whether the deductions exceed what could have been recovered through depletion deductions had they been capitalized. Similarly, gain on all mineral property could be required to be included in income to the extent of prior depletion deductions allowed or, alternatively, to the extent percentage depletion deductions allowed with respect to such property exceed those that would have been allowed under cost depletion.

102 As previously noted, the Administration proposal states that consideration could be given corporate liquidations, on a parallel basis with respect to real and personal property.

to applying the limits imposed by the recapture rules on nonrecognition transactions, such as

IV. ENTITY CLASSIFICATION

Present Law and Background

Classification as a partnership or corporation

Under present law, Treasury regulations provide that whether a particular entity is classified as an association taxable as a corporation or as a partnership, trust, or some other entity not taxable as a corporation is determined by taking into account the presence or absence of certain characteristics associated with corporations. These characteristics are (1) associates, (2) an objective to carry on business and divide the gains therefrom, (3) continuity of life, (4) centralization of management, (5) liability for entity debts limited to entity property, and (6) free transferability of interests. 103 These regulations are generally based on the principle stated in Morrissey v. Comm'r, 296 U.S. 344 (1935), in which the Supreme Court held that whether an entity is treated as a corporation depends not on its formal organization but on whether it more closely resembles a corporate than a noncorporate entity.

Of the characteristics mentioned above, the first two are common to both corporate and noncorporate business enterprises. Consequently, the remaining four factors are determinative. Treasury regulations state the corporate characteristics of an entity must make it more nearly resemble a corporation than a partnership or a trust for the entity to be treated as a corporation. 104 Although Morrissey suggested evaluation on a case-by-case basis, the Treasury regulations, while allowing for the presence of other "significant factors," simply count the presence or absence of the four stated factors; if fewer than three are present, an entity is not treated as a corporation. In this respect, the regulation goes further than Morrissey by providing that where there are an equal number of the critical "corporate" and "noncorporate" characteristics, the entity will not be classified as a corporation.

Attempts to expand the inquiry regarding partnership or corporation classification have not been successful. Regulations proposed in 1977105 would have tightened the test with respect to the continuity of life and centralized management factors, and generally would have required the examination of additional factors if an entity had two of the four corporate characteristics. The proposed regulations were intended as a response to criticism that the existing regulations deviated from the "resemblance test" on which they were based, as articulated by the Supreme Court in Morrissey. These proposed regulations were withdrawn one day after they were issued.

In addition, consideration of factors other than the four primary ones was limited in Larson v. Comm'r, 66 T.C. 159 (1976), acq. 19791 C.B. 1, in which the Tax Court held that a number of specified "other factors" were relevant only in evaluating the presence or absence of the four primary ones. The Internal Revenue Service later announced that it would follow Larson's method of evaluating such other factors.106 As a result, most limited partnerships formed under the Uniform Limited Partnership Act are not treated as corporations. These entities generally do not possess continuity of life and may often lack limited liability. 107

Treatment of partnerships and grantor trusts

If as a result of the legal tests described above, an entity is classified as a partnership, it will generally be treated as a conduit for income tax purposes. The partnership itself will have no liability for tax and all items of income, expense, credit, etc., are allocated to and accounted for by the partners, including limited partners. Similarly, if an entity is classified as a grantor trust, beneficiaries of the trust are treated as owners of a proportionate share of the trust's assets and account directly for the trust's items of income and expense. The grantor trust is often used, in a form known as a fixed investment trust, as a vehicle for the common ownership of investment assets. An example of such a trust is a socalled "mortgage pool," which involves the transfer of a group of mortgage loans to a trustee who holds the mortgages for the benefit of persons who have purchased or otherwise acquired interests in the trust.

Treatment of corporations

As discussed in Part II above, income earned by a corporation generally is subject to tax at the corporate level when earned and then subject to tax at the shareholder level when distributed. Nevertheless, several types of corporations are provided special exemption from this general scheme.

S corporations

In general, a corporation may elect to be treated under subchapter S of the Code (sec. 1361 et seq.) if it has 35 or fewer shareholders (none of whom are corporations or nonresident aliens), has not more than one class of stock, and is not a financial institution, a life insurance company, or one of several other types of corporations.

If such a corporation elects to be treated as subject to subchapter S, its shareholders generally account for a proportionate amount of the corporation's items of income, loss, deduction, and credit. The S

106 Rev. Rul. 79-106, 1979-1 C.B. 448.

107 Continuity of life generally does not exist under the Uniform Limited Partnership Act even if partners agree in advance to continue the partnership upon the death or withdrawal of a general partner. Treas. Reg. sec. 301.7701-2(b). See Rev. Proc. 85-22, Sec. 3.41, I.R.B. 1985-12, 13. In addition, limited liability has been held to be absent even though the only partner with personal liablity is a corporation, unless the corporation both does not have substantial assets and is a mere "dummy" acting as the agent of the limited partners. See Larson, supra, 66 T.C. at 173-176, 179-182. The Internal Revenue Service has announced a study that will reconsider the acquiescence in Larson to the extent the acquiesence is inconsistent with the minimum capitalization requirement of Rev. Proc. 72-13, 1972-1 C.B. 735. Ann 83-4, I.R.B. 1983-2, 31.

corporation itself generally has no tax liability for so long as the election is in effect.

Regulated investment companies

In general, to qualify as a regulated investment company ("RIC"), a corporation must be a domestic corporation that either meets or is excepted from certain registration requirements under the Investment Company Act of 1940 (15 U.S.C. 80), that derives at least 90 percent of its income from specified sources commonly considered investment income, that has a portfolio of investments which is sufficiently diversified, and that also meets certain other requirements. Mutual funds, for example, generally qualify as RICS.

If a corporation meets these requirements and elects to be treated as a RIC, it generally would be subject to the regular corporate tax, but would receive a deduction for dividends paid provided that the amount of its dividends paid is not less than an amount generally equal to 90 percent of its ordinary income, including taxexempt income. These dividends must be paid within a short period following the close of the RIC's taxable year and are generally includible as ordinary income to the shareholders.

A RIC that realizes capital gain income may be subject to tax at the corporate level at capital gains rates. If, however, the RIC pays dividends out of such capital gains, the dividends are deductible for the RIC in computing its capital gains tax and are taxable as capital gains to the recipient shareholders.

Real estate investment trusts

In general, an entity may qualify as a real estate investment trust ("REIT") if it is a widely held entity with freely transferable interests that would be taxable as an ordinary domestic_corporation but for its meeting certain specified requirements. These requirements relate to the entity's assets being comprised substantially of real estate assets and the entity's income being in substantial part realized from certain real estate and real estate related

sources.

If these requirements are met and the entity elects to be taxed as a REIT, like a RIC it generally would be subject to the regular corporate tax, and generally would be permitted a deduction for dividends paid to its shareholders within a short period after the close of its taxable year provided it distributes at least 95 percent of its taxable income, excluding capital gains. The treatment of capital gains for a REIT and its shareholders is similar to that for a RIC.

Cooperatives

Certain corporations are eligible to be treated as cooperatives and taxed under the special rules of subchapter T of the Code. In general, the subchapter T rules apply to any corporation operating on a cooperative basis (except mutual savings banks, insurance companies, most tax-exempt organizations, and certain utilities).

For Federal income tax purposes, a cooperative generally computes its income as if it were a taxable corporation, with one important exception-the cooperative may deduct from its taxable income patronage dividends paid. In general, patronage dividends