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Corporate Managers, Agency Costs, and the Rise of Double Taxation

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Corporate Managers, Agency Costs, and the Rise of Double Taxation William & Mary Law Review Volume 44 (2002-2003) Issue 1 Article 4 October 2002 Corporate Managers, Agency Costs, and the Rise of Double Taxation Steven A. Bank Follow this and additional works at: https://scholarship.law.wm.edu/wmlr Part of the Business Organizations Law Commons, and the Tax Law Commons Repository Citation Steven A. Bank, Corporate Managers, Agency Costs, and the Rise of Double Taxation, 44 Wm. & Mary L. Rev. 167 (2002), https://scholarship.law.wm.edu/wmlr/vol44/iss1/4 Copyright c 2002 by the authors. This article is brought to you by the William & Mary Law School Scholarship Repository. https://scholarship.law.wm.edu/wmlr CORPORATE MANAGERS, AGENCY COSTS, AND THE RISE OF DOUBLE TAXATION STEVEN A. BANK* TABLE OF CONTENTS INTRODUCTION ....................................... 169 I. THE ORIGINS OF A SEPARATE CORPORATE INCOME TAX ..... 173 A. Civil War and Reconstruction ...................... 173 B. State Law Developments in the Taxation of Corporations ................................ 176 C. FederalAdoption of a Separate CorporateIncome Tax . 178 II. THE ADOPTION OF AN UNDISTRIBUTED PROFITS TAX ...... 183 A. Campaign of 1932 .............................. 183 B. 1936 and the Revival of the UndistributedProfits Tax ....................... 192 III. DOUBLE TAXATION AS A TOOL IN THE ATTACK ON THE UNDISTRIBUTED PROFITS TAX .................... 198 A. Prelude to the Revenue Act of 1936 ................. 198 B. The Campaign to Defeat the Tax in the Revenue Act of 1936 ............................ 204 1. H ouse ...................................... 204 2. Senate ..................................... 213 3. Conference .................................. 226 * Visiting Professor, UCLA School of Law (2002-2003); Associate Professor, Florida State University College of Law. B.A. 1991, University of Pennsylvania; J.D. 1994, University of Chicago. Thanks to Barbara Banoff, Joseph Dodge, Christopher Hanna, Carolyn Jones, Peter Oh, and Daniel Schneider for their comments and suggestions. Previous versions of this paper were presented at the 2001 Annual Meeting of the Central States Law School Association at Michigan State University-Detroit College of Law and at a Florida State University College of Law Faculty Colloquium. Thanks to participants for all of their comments. Thanks also to Paul Berk (Ph.D. candidate, FSU History Department) and Michael Barry (J.D. 2001) for their research assistance and to the archivists at the Hoover Institution Library and Archives at Stanford University and the Center for American History at the University of Texas for their hospitality and help in locating documents. This project benefitted from a summer research grant from Florida State University College of Law. 167 168 WILLIAM AND MARY LAW REVIEW [Vol. 44:167 C. The Rise and Fall of the UndistributedProfits Tax .... 229 1. The Aftermath of the Revenue Act of 1936 ........ 229 2. 1937 Economic Downturn ..................... 234 3. Revenue Act of 1938 .......................... 239 a. Subcommittee Plan ........................ 239 b. H ouse ................................... 242 c. Senate ................................... 246 d. Conference ............................... 252 4. Revenue Act of 1939 .......................... 255 CONCLUSION . ........................................ 259 2002] THE RISE OF DOUBLE TAXATION 169 INTRODUCTION Corporate income is currently taxed twice-first to the cor- poration when earned and a second time to the shareholder when distributed as dividends.1 This "double taxation" is a much reviled, but stubbornly persistent feature of our current system.2 Few, if any, commentators suggest that we would consciously adopt it if we were working from a blank slate,' and most openly recommend double taxation's demise.' Even the nineteenth-century movement to personify the corporation as a separate entity, which is often considered the foundation for the separate corporate income tax and, by implication, double taxation,5 was followed by an income tax act carefully crafted to avoid imposing a second layer of tax on 1. I.R.C. § 11 (2000) (imposing a tax on corporate income); id. §§ 301, 316 (imposing a shareholder-level tax on distributions in the form of dividends). This is sometimes referred to as the "classical" system because it still treats the corporation and shareholder as separate taxpayers rather than integrating the corporate and shareholder-level taxes. See Michael J. Graetz & Alvin C. Warren, Jr., Integration of Corporate and Individual Income Taxes: An Introduction,84 TAX NOTES 1767, 1768 (1999). As Graetz and Warren point out, the classical system does not always result in double taxation. For example, corporate income is not taxed twice when a shareholder is exempt from tax or when corporate income is paid out as deductible interest payments. In fact, it is not even taxed once when it is paid out as deductible interest to a foreign or other tax-exempt holder of corporate debt. Id. at 1768. 2. See, e.g., CHARLES E. MCLURE, JR., MUST CORPORATE INCOME BE TAXED TwiCE? 2-3 (1979); Alvin Warren, The Relation andIntegration of Individual andCorporate Income Taxes, 94 HARV. L. REV. 719, 720 (1981). 3. For one of the few defenses of double taxation, see Jeffrey L. Kwall, The Uncertain Case Against the Double Taxation of CorporateIncome, 68 N.C. L. REv. 613 (1990) (arguing that double taxation protects the progressivity of the income tax). 4. See AMERICAN LAW INSITUTE, FEDERAL INCOME TAX PROJECT- INTEGRATION OF THE INDIVIDUAL AND CORPORATE INCOME TAXES - REPORTER'S STUDY OF CORPORATE TAx INTEGRATION (1993); U.S. DEP T OF TREAStmY, INTEGRATION OF THE INDIVIDUAL AND CORPORATE TAX SYSTEMS: TAXING BUSINESS INCOME ONCE (1992); Joseph M. Dodge, A Combined Mark.to-Market and Pass-Through Corporate-ShareholderIntegration Proposal, 50 TAX L. REV. 265 (1995); John K McNulty, CorporateIncome Tax Reform in the United States: Proposals for Integration of the Corporate and Individual Income Taxes, and InternationalAspects, 12 INTL TAX & Bus. L. 161 (1994); George K. Yin, Corporate Tax Integrationand the Search for the PragmaticIdeal, 47 TAX L. REV. 431 (1992). 5. See, e.g., AMERICAN LAW INSTITUTE, FEDERAL INCOME TAX PROJECT, TAXATION OF PRIVATE BUSINESS ENTERUISES: REPOltTER'S STUDY 35-36 (1999); Maijorie E. Kornhauser, CorporateRegulation and the Originsof the CorporateIncome Tax, 66 IND. L.J. 53,136 (1990); cf. RICHARD GOODE, THE CORPORATION INCOME TAX 24-25 (1951) ("In the legal sense, of course, the corporate and individual income taxes do not result in double taxation. The corporation and its stockholders are different legal persons and have separate incomes.*). WILLIAM AND MARY LAW REVIEW [Vol. 44:167 corporate income.6 Not until 1936 was corporate income fully subject to two layers of tax. Double taxation's origins, therefore, have remained a mystery for modem observers. This Article seeks to resolve this mystery by examining the circumstances leading to the imposition of the full double tax in 1936. Although the corporate-level tax traces its roots to the nineteenth century,7 and the corporate and shareholder-level taxes have coexisted since the first post-Sixteenth Amendment revenue act was adopted in 1913," double taxation was at least partially or fully alleviated during the early years of the income tax. In the Revenue Act of 1936,' however, President Roosevelt introduced a radical plan to combat corporate "hoarding" of earnings by replacing the corporate income tax with an undistributed profits tax and a repeal of the exemption for dividends from the "normal" individual income tax.' If distributed as dividends, corporate income would only be subject to the individual income tax. 1 If retained, however, corporate income would be subject to a punitive undistributed profits tax and, upon distribution in later years, the individual income tax as well.' Managers bitterly fought the proposal, claiming that its coercive undistributed profits tax constituted a dangerous and unwarranted governmental interference with the operation of their businesses." As part of an ill-fated compromise, Congress retained the corporate income tax, along with a more 6. See Tariff Act of 1894, ch. 349, § 28,28 Stat. 509,554. For a more complete description of the circumstances giving rise to the adoption of the first separate corporate income tax, and a refutation of the traditional view that the separate corporate income tax arose because of developments in entity theory, see Steven A. Bank, Entity Theory as Myth in the Origins of the CorporateIncome Tax, 43 WM. & MARY L. REV. 447, 462 (2001). 7. See Bank, supra note 6, at 462. 8. Tariff Act of 1913, ch. 16, 38 Stat. 114. 9. Revenue Act of 1936, Pub. L. No. 74-740, 49 Stat. 1648. 10. At the time, all individual income was subject to a *normal,* or base flat rate tax. When income reached a certain point, an additional surtax was applied at rogressive rates. Dividends were exempt from the normal tax, but not the surtax rates. See infra text accompanying notes 58-73. 11. See Revenue Act of 1936, Pub. L. No. 74-740, 49 Stat. 1648. 12. See id. 13. Corporations had been subject to an accumulated earnings tax since the first post- Sixteenth Amendment income tax in 1913, but it only applied in the event that a corporation retained income with the purpose of evading the high surtax rates. This intent requirement was difficult to prove. Under Roosevelt's proposal, by contrast, the undistributed profits tax applied regardless of the purpose for the retention. See infra text accompanying notes 170-7
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