Tax Code Changes: Reforms That Make Sense

By Jack Butler
From the July 2012 issue of Columbus CEO

President Barack Obama wants to raise income tax rates. Republicans want to lower rates. People hear about the fat-cat tax, the flat tax and the VAT tax. To show that he likes corporations, the president has proposed a 28 percent corporate tax rate—a rate that would be lower than that of many countries. But such a proposal also eliminates deductions and other tax tools for lowering taxable income, resulting in corporate taxes that would actually be higher for a majority of corporations.

Americans could benefit from a more sensible tax code when it comes to businesses, and it’s not all about tax rates. It’s more about tax policy. Here are some suggested reforms:

  • Corporations could be allowed a deduction for dividends paid, thus eliminating a double tax on corporate earnings that flow to shareholders. This is not a new idea. A dividend deduction would lower the total corporate and individual tax on dividends for Ohio taxpayers to approximately 20 percent, and for those in states without an income tax to 15 percent. A double tax is bad policy.
  • Creating two capital gain rates—a lower rate for gains from true capital investing and a higher rate for trading gains—makes sense. True capital investing provides funding for a company, which it can use to innovate, grow and create jobs.
  • Flow-through entities such as LLCs and sub-S corporations do not pay income tax—their owners do, even if the owners do not receive distributions from the company. To avoid this problem, the tax code should provide that if a flow-through entity does not distribute at least 35 percent (the highest individual federal tax rate) of its taxable income, it is the entity that is then taxed on the shortfall.
  • It may be time to eliminate the “last in, first out” tax advantage. Tax LIFO means a seller of inventory can use the cost of the last items bought or created as the cost of the older (first) items it sells. This lowers tax profit on the inventory sold. In a “just in time” world, LIFO rules are outdated. However, elimination should be phased in, unlike the 1986 elimination of the tax loss rules, which were not phased in and destroyed the savings and loan industry and cost U.S. taxpayers approximately $800 billion.
  • The so-called “carried interest” of a private equity investor’s stake in a venture or company is taxed at a 15 percent federal rate—because the private equity (PE) firm and its owners receive either dividends or capital gains proceeds. The disclosure of presidential candidate Mitt Romney’s tax returns revealed that his tax rate was just under 15 percent due to his carried interest income, creating a brouhaha among the media and Congressional Democrats.

In a carried interest situation, an investment transaction is structured as a partnership between the PE firm and investors. In large deals, the firm usually gets 20 percent of the dividend and cash-out profits and the investor gets 80 percent. The interest of the PE firm is “carried” by the money invested by others. Media pundits claim Wall Street firms that do this are exploiting a tax loophole. But there is no loophole: The applicable partnership tax rules here have been in place for decades. The issue is one of tax policy.

A change in the tax code might look like this: The deal instigator (promoter) would be deemed to invest 20 percent of the original cash investment. When the deal cashes out, sums received by the promoter equal to the deemed investment would be taxed at a flat 25 percent (halfway between the 15 percent capital gains and 35 percent ordinary income rates). Further, all deemed investments under $2 million (i.e., deals with total investments of $10 million or less) and all real estate deals would be exempt.

 

And what about corporations not paying tax on overseas profits? It may be best to provide a three-year rolling period and then tax all such profits, one year at a time, that are not repatriated. There could be a credit for foreign taxes paid and a deduction against the repatriated income for dollars that are invested into privately held U.S. businesses.

Should there be tax subsidies for green energy projects when green energy, after years and years of endeavor and billions of dollars of subsidies, only produces 1.3 percent of our energy? No; let the free market make it work.

If the corporate tax rate is lowered, the same rate also should apply to pass-through entities (S corporations and limited liability companies) to level the playing field. The focus should be on policy and not just rates.

Jack Butler is a partner in the business law practice area at Carlile Patchen & Murphy. He can be reached at (614) 628-0873 or jbutler@cpmlaw.com.

 Reprinted from the July 2012 issue of Columbus C.E.O. Copyright © Columbus C.E.O.