Taxation of Private Enterprises

Presentation to

President’s Advisory Panel on Federal Tax Reform

David J. ShakowProfessor Emeritus, University of Pennsylvania

Law School

Director, KPMG, LLP

Taxation of Businesses

• Businesses that are not sole proprietorships are generally taxed in one of three ways– C corporations (separately taxed)– S corporations– Partnerships (generally including LLCs)

• S corporations and partnerships are taxed under a “passthrough” structure – their owners are taxed as if they had earned the entity’s income directly

• Since the IRS has allowed LLCs to be taxed as partnerships, there has been a movement towards using the partnership form for small businesses

Partnership Taxation

• The partnership tax rules provide much flexibility• This allows the tax law to properly tax many

different kinds of transactions• The flexibility of the partnership tax rules has also

allowed them to be used in the past in tax abusive transactions

• To prevent this, Congress has added more and more complex rules to the partnership structure

Problems with Partnership Taxation

• Complicated partnership tax rules apply to simple partnership transactions, not just complicated ones– Sale of a partnership interest

– Redemption of a partner

– Transfer of partnership property to a partner

• Anecdotal evidence strongly suggests that these rules are not complied with by smaller partnerships

ALI Study - Basics

• The ALI reporters’ study tried to deal with this situation in a number of ways

• It accepted Congress’s distinction between publicly-traded entities and other entities– No matter their form, publicly-traded entities

are taxed as C corporations– Publicly-traded entities are free to choose their

form for state law purposes without affecting Federal taxation

ALI Study - Proposal

• The ALI study extended this concept to privately-held entities: no matter their form for state law purposes, they are taxed the same way for Federal tax purposes

• It chose the passthrough structure for privately-held entities– Each owner’s income is taxed at the owners’ tax rate,

not at a rate determined by the success of the entity– There is no essential distinction between sole

proprietorships and other privately-held entities

ALI Proposal - Specifics

• The ALI study continued to apply the full set of partnership tax rules under current law to entities that needed flexibility in their operations

• The study concluded that entities owned solely by domestic individuals, who divide all income and losses in a straightforward manner, could be governed by a simpler set of rules

• Starting from that conclusion, it developed a simplified system for passthrough treatment that does not pose the major compliance burden of the partnership tax rules– The system looks very much like current Subchapter S

Transition Alternatives• This new structure could be applied only to newly-

created entities• It could be applied to all existing entities

– Entities currently not taxed as passthroughs could be treated as liquidated. The resulting tax liability could be:

– Forgiven– Taxed at a lower rate– Payable over time– Some combination of the above

– Entities currently not taxed as passthroughs could be moved to that system over time

• You must compare the imprecision of transition rules to the inefficiencies of current law rules

Taking the Next Step

• The current dichotomy between separately-taxed corporations and passthrough entities is further exacerbated by this proposal

• If the Commission supports this step, it could consider the advantages of eliminating the tax at the level of publicly-traded entities

• This could be accomplished by taxing owners of such entities on the change in value of their publicly-traded interests

Areas for Further Consideration

• How are tax-exempt owners to be treated?

• How are foreign operations (subject to taxes in foreign jurisdictions) to be taxed?