II. THE TWO-TIER TAX ON DISTRIBUTED INCOME AND CERTAIN EXCEPTIONS-PROPOSALS REGARDING

In general

DIVIDEND DEDUCTIONS

Present Law and Background

Under present law, corporations and their shareholders generally are separate taxable entities. A corporation's taxable income is subject to a corporate income tax at graduated rates with a maximum 46 percent rate for taxable income exceeding $100,000. Distributions by a corporation to its individual shareholders, to the extent of the corporation's current and accumulated earnings and profits, generally are taxable as ordinary income to the shareholders, at graduated rates up to 50 percent. Thus, corporate income that is distributed to shareholders generally is subject to two tiers of tax.

4

In contrast, corporate income that is not distributed to shareholders is subject to current tax at the corporate level only. To the extent that income retained at the corporate level is reflected in an increased share value, the shareholder may be taxed at favorable capital gains rates upon sale or exchange (including certain redemptions) of the stock or upon liquidation of the corporation. If an individual shareholder retains stock until death, the appreciation can pass to the heirs free of income tax (sec. 1014).5

Various deductions and credits can reduce or eliminate the corporate level tax. Corporate income distributed as interest payments to creditors rather than as dividends to shareholders is not taxed at the corporate level, since the corporation generally may deduct interest payments (but not dividend payments) from its taxable income.

The deductibility (within reasonable limits) of funds paid as salaries to shareholders who are also employees, reduces corporate tax and involves current taxation of the payment to the shareholder.R

3 Earnings and profits (sec. 312) are a measure of a corporation's economic income that fre quently exceeds a corporation's taxable income. See discussion of earnings and profits in Part infra.

Distributions with respect to stock that exceed corporate earnings and profits are not taxed as dividend income to shareholders but are treated as a tax-free return of capital that reduces the shareholder's basis in the stock. Distributions in excess of corporate earnings and profits that exceed a shareholder's basis in the stock are treated as amounts received in exchange for the stock and accordingly may be taxed to the shareholder at capital gains rates.

5 In addition, in the case of certain corporate distributions in liquidation or in certain redemptions, unrealized appreciation in corporate assets can escape corporate tax entirely (apart from the recapture of specified items, such as certain prior depreciation deductions). In such cases, only a capital gains tax at the shareholder level may be imposed on the appreciation when the assets are distributed to the shareholders or sold to a third party and the proceeds distributed. The absence of taxation at the corporate level in these circumstances is discussed in Part III, below.

6 It is possible that salaries of some shareholder-employees may be inflated to some extent within a range of asserted reasonableness, leaving little or no reported taxable income at the corporate level.

Other provisions that may affect corporate taxable income include preferential accounting methods and tax preferences under the Code that are intended as investment incentives, such as the investment tax credit, accelerated depreciation, and the exemption of interest on State and local obligations. Utilization of such provisions can reduce or eliminate the corporate level tax without requiring distributions to shareholders or otherwise resulting in current recognition of the income at the shareholder level. Corporations are subject to an "add-on" minimum tax on certain tax preferences.7

Certain Code provisions are designed to prevent unreasonable accumulations of corporate earnings (sec. 531 et seq.) or to cause the distribution of corporate earnings of "personal holding companies" to shareholders (sec. 541 et seq.). However, the provisions relating to unreasonable accumulations generally depend upon taxable income (with certain adjustments) and thus do not affect accumulations when a corporation is able to reduce its taxable income with certain preference items such as accelerated depreciation. The provisions intended to cause distributions of personal holding company earnings also generally depend upon taxable income and further apply only to certain closely held corporations that derive a substantial portion of their income from generally passive investments or certain personal services provided by shareholders.8

Exceptions

There are several departures in present law from this general scheme of corporation and shareholder taxation. Certain corporations are given direct relief from the corporate tax. Relief from taxation at the shareholder level is given in certain circumstances.

Relief from the corporate level tax

In general, direct relief from the corporate income tax is given to income earned by corporations electing under subchapter S ("S Corporations"), regulated investment companies ("RICs") (such as mutual funds), and real estate investment trusts ("REITs")." Income earned by an S corporation is allocated among and taxed directly to its shareholders regardless of whether such income is distributed. Income earned by a RIC or a REIT is subject to a tax at the corporate level, but both RICS and REITs are permitted deductions for dividends paid, in effect eliminating the corporate tax on earnings that are distributed. Moreover, in order to maintain

7 The corporate minimum tax is discussed in a separate pamphlet, Joint Committee on Taxation, Tax Reform Proposals: Tax Shelters and Minimum Tax (JCS-34-85), August 7, 1985.

The Internal Revenue Service has ruled that certain corporate income from shareholder personal services is not subject to personal holding company tax, even though the client or customer may expect only the shareholder to perform the service, if someone else might theoretically be called upon to perform it. See Rev. Rul. 75-67, 1975-1 C.B. 169; Rev. Rul. 75-250, 1975-1 C.B. 172. A corporation earning only such income from the performance of services by its shareholders (for example, a professional corporation whose business consists of a shareholder performing medical services) could earn income subject to the graduated corporate rates and generally could accumulate a total of at least $150,000 without being subject to the accumulated earnings tax. 9S corporations are corporations that meet restrictions on the number of shareholders and certain other requirements and that also elect special treatment under Subchapter S. RICs and REITs are entities that derive a substantial portion of their income from essentially passive investments and that absent special provisions in the Code would otherwise be taxed as ordinary corporations. These entities are discussed further in Part IV below.

their status as a RIC or a REIT, such entities are required to distribute most of their income currently.

Direct relief from the corporate tax is also granted to cooperatives subject to subchapter T of the Code. In general, such cooperatives are also subject to tax at the corporate level but are given deductions for dividends paid out of profits derived from transactions with their members. Additionally, a cooperative may exclude income attributable to qualified per-unit retain allocations and redemptions of nonqualified per-unit retain certificates.

Only amounts paid within 8-1/2 months of the close of the cooperative's taxable year are entitled to this special treatment. As a result, cooperatives generally pay corporate tax only on profits that are not distributed, and on profits not derived from transactions with members. 10 Cooperative members who receive dividends will treat the dividends as income, reduction of basis, or some other characterization that is appropriate based on the nature of the members' transactions with the cooperative.11

Additionally, certain dividends paid with respect to stock held in an employee stock ownership plan and distributed to plan participants are deductible by the corporation (sec. 404(k).12

Common to these areas of direct relief from the corporate income tax generally is a concept of current taxation at the shareholder (or member) level of income that is not taxed to the corporation.

Relief from the shareholder level tax

Individual shareholders.-Under present law, the first $100 of qualified dividends received by an individual shareholder ($200 by a married couple filing jointly) from domestic corporations is excluded from income (sec. 116). Thus, to this limited extent, distributed corporate earnings are subject to tax at the corporate level only.

The dividends exclusion for individuals does not apply to dividends received from a tax-exempt organization (under section 501), a farmer's cooperative, a REIT, or a mutual savings bank (that received a deduction for the dividend under section 591), or to an ESOP dividend for which the corporation received a deduction. The exclusion is limited with respect to dividends received from a RIC. Under the Economic Recovery Tax Act of 1981, a limited amount of dividends in the form of stock of certain public utility corporations, paid prior to January 1, 1986, are exempt from shareholder tax; absent this special rule, such dividends would otherwise be taxable because the shareholder has elected to receive the stock in

10 In addition, tax-exempt farmers' cooperatives qualifying under section 521(b) of the Code may may receive additional relief from the corporate level tax since they may deduct patronage dividends paid to the full extent of their net income and also may deduct, to a limited extent, dividends on common stock.

11 In some instances, cooperatives may operate on a "federated" basis, i.e., local cooperatives are patrons of other cooperatives operating on a regional or national basis. These cooperatives (and their individual patrons) may have different taxable years. This fact combined with the rule permitting patronage dividends to be deducted if paid within 8-1/2 months after close of a cooperative's taxable year can result in patronage earnings being distributed to a lower-tier cooperative and subsequently to an individual patron (generally the only party who is taxed on the income) in a taxable year subsequent to the year in which the income is earned.

12 Employee stock ownership plans are discussed in a separate pamphlet prepared by the staff of the Joint Committe on Taxation.

stead of other property (sec. 305(e)). In effect, such amounts are not subject to shareholder tax if reinvested in the corporation. 12a

Corporate shareholders.-Under present law, subject to certain exceptions, corporate shareholders receiving dividends generally are entitled to a deduction of 85 percent of the dividends received (sec. 243). Under the present 46 percent maximum regular corporate tax rate, the deduction means that the maximum corporate rate on dividends received from another corporation is 6.9 percent (.46 x (1-.85)). Dividends received from certain members of an affiliated group are eligible for a 100 percent dividends received deduction. In addition, pursuant to Treasury regulations, dividends received by one member of an affiliated group filing a consolidated return from another member of the group are not taxed currently to the recipient.

However, dividends received from another member of a consolidated group from pre-affiliation earnings and profits (deemed reflected in basis) or from post-consolidation earnings and profits that have increased the basis of the parent corporation's stock in the subsidiary, reduce the basis of the recipient corporation's stock in the payor subsidiary. (Treas. Reg. sec. 1.1502-32.)

In addition, any corporate shareholder's basis in shares with respect to which an "extraordinary dividend" was received may be reduced by the amount of the dividend that was not taxed unless the stock has been held for more than one year (sec. 1059). An “extraordinary dividend" is a dividend exceeding 10 percent of the basis of such common stock with respect to which the dividend was paid, or 5 percent of the basis of such preferred stock. Certain dividends are aggregated for this purpose.

The dividends received deduction is available whether or not the dividends represent earnings that were taxed to the the distributing corporation.

The dividends received deduction does not apply to certain dividends, including dividends received from a REIT, and the availability of the dividends received deduction is limited with respect to dividends received from a RIC.

The dividends received deduction is also not available with respect to dividends received on stock that is not held (with a substantial risk of loss) for a specified period, generally more than 45 days (90 days in the case of certain preferred stock) (sec. 246). The deduction is also limited for dividends received on certain "debt-financed portfolio stock" (sec. 246A).

International aspects

Dividends paid by a U.S. corporation to foreign shareholders generally are subject to a 30-percent withholding tax (secs. 1441, 1442) and may be subject to tax in the recipient's country as well. 13 Var

12a However, stock received as an untaxed dividend under section 305(e) is treated as having a zero basis. Moreover, a shareholder who disposes of any stock of the distributing corporation within a year of the record date of such a distribution is treated as having disposed of the stock received as a dividend and the disposition is ineligible for capital gains treatment.

13 Certain dividends from a U.S. corporation that earns less than 20 percent of its gross income from U.S. sources (an "80-20 company") are not subject to U.S. tax when paid to foreign shareholders (secs. 861(a)(2)(B), 871(a) and 881; Treas. Reg. sec. 1.881-2). The Administration proposal would eliminate this rule. The foreign tax aspects of the Administration proposal are disContinued

ious income tax treaties substantially reduce the rate of the U.S. withholding tax, however.

In the case of foreign investment in U.S. corporate equity, corporate income is taxed at the corporate level (by the United States) and, on distribution, at the shareholder level (by the United States and perhaps another country), thus generally producing a two-tier tax on corporate income.

In general, dividends received by a U.S. corporation from a foreign corporation are not eligible for the dividends received deduction, even though the foreign corporation may have paid U.S. tax. However, where at least 50 percent of a foreign corporation's gross income is effectively connected with a U.S. trade or business, a portion of the dividends paid by such corporation to a U.S. corporate shareholder is eligible for the dividends received deduction. That portion generally is based on the percentage of the foreign corporation's income that is effectively connected with its U.S. trade or business (sec. 245).

In general

Administration Proposal

Under the Administration proposal, a domestic corporation would be entitled to a deduction equal to 10 percent of the dividends paid from earnings that have borne the regular corporate tax. The deduction would not be available to corporations that otherwise are subject to special tax regimes, e.g., regulated investment companies and real estate investment trusts.

Distributions that are not treated as dividends would not be eligible for the deduction. However, distributions that are not dividends in form but are so treated for income tax purposes (e.g., certain pro rata stock redemptions) would be eligible for the deduction. In addition, the dividends received deduction for corporations would be changed from the present law 85 percent or 100 percent based on the degree of stock ownership, to 90 or 100 percent based on whether or not the payor is entitled to the dividends paid deduction (without regard to the degree of stock ownership).

Under the Administration proposal, the dividends paid deduction would be treated like an ordinary business deduction for the purpose of determining the corporation's income tax liability, including the liability for estimated tax payments. 14 Net operating losses attributable to the dividends paid deduction would be available to be carried back and forward to the extent permitted by present law.

The qualified dividend account

Under the Administration proposal, which would generally be effective on January 1, 1987, dividends would be eligible for the dividends paid deduction only to the extent that such dividends do not

cussed in a separate pamphlet, Joint Committee on Taxation, Tax Reform Proposals: Taxation of Foreign Income and Foreign Taxpayers (JCS-25-85), July 18, 1985.

14 The Administration proposal does not discuss the effect of the dividends paid deduction on a corporation's earnings and profits. It would appear that the amount of the dividends paid deduction should not itself reduce earnings and profits, which would be reduced by the full amount of a dividend, whether or not deductible.