A Populist Political Perspective of the Business Tax Entities Universe: Hey the Stars Might Lie, but the Numbers Never Do John W
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College of William & Mary Law School William & Mary Law School Scholarship Repository Faculty Publications Faculty and Deans 2000 A Populist Political Perspective of the Business Tax Entities Universe: Hey the Stars Might Lie, but the Numbers Never Do John W. Lee William & Mary Law School, [email protected] Repository Citation Lee, John W., "A Populist Political Perspective of the Business Tax Entities Universe: Hey the Stars Might Lie, but the Numbers Never Do" (2000). Faculty Publications. 211. https://scholarship.law.wm.edu/facpubs/211 Copyright c 2000 by the authors. This article is brought to you by the William & Mary Law School Scholarship Repository. https://scholarship.law.wm.edu/facpubs A Populist Political Perspective of the Business Tax Entities Universe: "Hey the Stars Might Lie But the Numbers Never Do"t John W. Lee* I. Introduction .... 887 II. Conventional Wisdom: Avoidance of Double Taxation, Plus Limitation of Liability Without S Corporation Restrictions, Make LLCs the Tax Entity of Choice for Small Business . 891 A. Overview of Entity Taxation . 891 1. Corporation Taxation . 891 2. Passthrough Entity Taxation . 892 B. Limitation of Liability . 897 C. Conventional Wisdom-Death of Private C Corporations and Non-LLC Passthroughs . ............. 898 ill. Reality of Inside Shelter for Small Income Private C Corporations and Perceived Residual Advantages of S Corporations . 903 t Line from Mary-Chapin Carpenter and Don Schlitz "I Feel Lucky" (1992 Columbia). * John William Lee, ill, Professor of Law, College of William & Mary. B.A. 1965, University of North Carolina; LL.B. 1968, University of Virginia; LL.M. (Taxation) 1970, Georgetown University. I am thankful for the suppon given by a College of William & Mary School of Law Summer Grant; and, in chronological order, the research assistance of Timothy Hrynick, William & Mary Law Class of 1991 and LL.M., 1992, as to the 1981 Congressional floor debate on inside rates for small income corporations; Anne-Marie Miles, Law Class of 1998, in canvassing jurisdictions as to new entity fonnation; Allan G. Donn, Esq., father of the Virginia LLC statute, for bringing to my attention the International Association of Corporation Administrators (IACA) Annual Repon of the Jurisdictions and giving me a copy of the 1997 Annual Repon; Charlotte E. Daniel, Clerk of the Virginia State Corporation Commission and past president of IACA, for kindly giving me her copy of the 1998 Annual Repon and for preparing the 1997 Annual Repon; Trish Bogenrief, Vice President, LEXIS' Document Services, for sending me the 1999 Annual Repon; Felicia Bunon for preparing the Appendix; and Tim K. Palmer, Law Class of 2000, for help in reviewing and assembling foomote sources. The many contributions from professors and practitioners are noted in text or foomotes. I am grateful for all their help. Any errors are my responsibility. 886 Texas Law Review [Vol. 78:885 A. Inside Shelter of Small Income Private C Corporation . 903 1. Statistics of Income Data . 903 2. Business Entity Ownership by High Income Individuals . 908 3. Splitting Income Between Private C Corporation and Entrepreneur . 910 4. Inside Private C Shelter as Tax Expenditure ........ 914 5. Avoidance of Second Level of Shareholder Taxation ... 916 B. Inside Shelter for Moderate Income Private C Corporations ............................. 921 C. Factors Outweighing Inside Shelter of Private C Corporations . 922 1. Factors Militating in Favor of ILC as Choice of Entity . 922 2. Factors Militating in Favor of S Corporations and C to S Corporation Conversions . 924 D. S Corporations ~rsus Other Passthrough Entities . 927 1. Conventional Wisdom . 927 2. Familiarity Breeds Predilection . 929 3. Wlge and Self-Employment Tax Avoidance ......... 930 E. Facts on the Ground as to Choice of Tax Entity . 936 1. Statistics of Income Data . 936 2. International Assodation of Corporation Administrators Annual Report of the Jurisdictions Data . 942 IV. Populist Perspective . ·. 945 A. Overview of Populism ........................ 945 B. Horizontal and ~rtical Equity and Private C Inside Shelter ................................. 947 1. In the Beginning Thars: Focus on Horizontal Inequity .. 950 2. In the Middle Thars: Focus on Inside "Wtimate" Tax Shelter . 959 3. In the Present Thars: Focus on ~rtical Inequity ..... 960 V. Political Perspective . 962 A. Origins of the Inside Graduated Corporate Tax Rates .... 962 B. 1954 Code .............................. 964 C. 1986 Code: The Hidden Hand (Fist) Is Revealed ....... 970 D. Beyond Political Rhetoric ..................... 974 VI. Conclusion ................................. 979 VII. Appendix . 986 2000] Business Tax Entities 887 I. Introduction The conventional wisdom presented in Part II holds that the choice of tax entity for a new, closely held or private, small income venture is a passthrough entity. In particular, the Limited Liability Company (LLC), the new kid on the block in the 1990s, is the conventional choice, due to its limitation of liability coupled with its hassle-free single level of federal income taxation. 1 Part III shows that the contrary reality in taxland is that either the regular or Subchapter C corporation ("C Corporation") or the Subchapter S corporation ("S Corporation") tends in most market segments to be the tax entity of choice for small businesses conducted in an entity form rather than as a sole proprietorship. As discussed in Part Ill, in all but one state new corporation formations (without differentiation between C and S Corporations) outnumber new LLC formations-usually by a margin of2:1 to 3:1 or greater for 1995-1998.2 Notwithstanding the concern of conventional wisdom over double taxa tion of C Corporations and shareholders3 (first inside at the corporate level and second outside at the shareholder level), profitable, small income, private C Corporations and their mostly high income, active owners appar ently pay less federal income tax at the owner and entity levels combined than they would under direct passthrough taxation with tax-free withdrawal of profits, as in a single level of taxation LLC or S Corporation. 4 Part III reveals that thirty-seven percent of C Corporations (over 750,000, accounting for five percent of C Corporation income) report, on the average, about $40,000, which is taxable at fifteen percent (with sixty-one percent reporting no income or a loss).5 In sharp contrast, eighty percent of their owners are taxable at the higher individual income brackets (from 31% to 39.6% before phase outs).6 Furthermore, a second level of outside shareholder-level taxation on the retained earnings is avoided at 1. See, e.g., Susan Pace Hamill, The Limited Liability Company: A Catalyst Exposing the Corporate Integration Question, 95 MICH. L. REv. 393, 393-94 (1996); Don W. Llewellyn & Anne O'Connell Umbrecht, No Choice of Entity After Check-the-Box, 52 TAX LAW. 1, 2 (1998); Larry E. Ribstein, The New Choice ofEntity for Entrepreneurs, 26 CAP. U. L. REV. 325, 331 (1997). For the "new kid on the block" metaphor I am indebted to Jimmy G. McLaughlin, Commentary: The Limited Liability Company: A Prime Choice for Professionals, 45 ALA. L. REV. 231, 231 (1993); see also Richard M. Horwood & Jeffrey A. Hechtman, The Limited Liability Company: The New Kid in Town, 20 J. CORP. TAX'N 334, 334-35 (1994); Mark Rosencrantz, Comment: You Wanna Do What? Attorneys Organizing as Limited Liability Pannerships and Companies: An Economic Analysis, 19 SEA TILE U. L. REV. 349, 359 (1996). 2. See infra notes 312-27 and accompanying text. 3. See infra notes 88-111 and accompanying text. 4. See infra notes 150-51, 156-62, 173-74, 190-97, 200 and accompanying text. 5. See infra notes 128-32, 145-49 and accompanying text. 6. See infra notes 142-43, 147, 169-71 and accompanying text. Phase-outs of personal exemptions, deductions, and wage taxes can raise the top effective rate to 45%. See infra note 148 and accomoanving text. 888 Texas Law Review [Vol. 78:885 least half the time, when the shareholder holds the small C Corporation private stock (or public C stock received in a tax-free reorganization for such private stock) until her death without receiving dividends.7 When the taxation is not avoided, it is greatly reduced on a present value basis by a long-deferred and often installment-reported capital gains sale. 8 Part ill calculates that the splitting of business income between (1) compensation to shareholder-employees taxed at higher individual income graduated rates and (2) profits left in the private C Corporation taxed at the lowest graduated corporate rates9 amounted, for 1993, to an annual tax expenditure or subsidy of $3 to $4 billion as to such 750,000 profitable small income, mostly private C Corporations.1° For 1993, there was also an at least equal annual tax expenditure benefitting about 33,500 moderate income, mostly private C Corporations (average income of around $2,000,000 subject, on the average, to a fiat thirty-four percent corporate income tax), accounting for over ten percent of C Corporation income. 11 For this latter segment of private companies the spread is between the fiat thirty-four percent inside corporate rate and the highest outside individual rate of forty-five percent federal income and wage taxes combined. 12 The Statistics of Income Division (SOl) of the Internal Revenue Service projects average annual decreases of 1.12% in 1999-2005 of corporate income Form 1120-A tax returns (filed by the smallest income and asset C Corporations, with gross receipts, total income and assets each not in excess of $500,000). 13 This asset category shows disproportionate losses and a very small share of corporate income. 14 Such future decline might tum out to be attributable mostly to a shrinkage in the number of C Corporations reporting no income or a loss (sixty-one percent in 1993)15 due to the phase-out over this period of the C Corporation tax advantage 7.