IRS Classifies Businesses As Big Or Small

IRS research data has looked at tax statistics to compare different kinds of businesses to distinguish "small business" from other kinds of businesses.

Overview

Lots of business returns (about 20 million out of 44 million) involve trivial instances of self-employment or income from property that don't amount to a regular business establishment in the traditional sense.

Of the remaining 24,184,000 businesses, about 246,000 business entity returns (and the pass through income of their partners and shareholders) involve big businesses (defined at having income of $10,000,000 or more per year). Less than a third of big businesses by this definition are organized as C corporations. The vast majority of the rest are taxed as partnerships or S corporations (with 6,000 structured as sole proprietorships or individually owned rental income sources). S corporations are more common than C corporations or partnership taxed corporations including LLCs for these entities (although the biggest big businesses are almost exclusively organized as C corporations). The big businesses (other than C corporations) collectively had 1,240,000 owners (although many were owners with only passive business income).

In between are 23,942,000 small businesses. Of these, 4,942,000 have employees and 19,000,000 do not. Moreover, a significant number of 1,760,000 S corporations and 864,000 C corporations with employees (about half of the small businesses with employees) employ only the business owner or members of that business owner's family whose are claimed on the business owners' tax returns (although the exact number was not possible to discern from the data available in this study).

Of course, an entity that files its taxes on Schedule C, Schedule E or with a Form 1065 partnership return could actually be a limited liability companies or limited partnerships (and other data show that a very large portion in fact are limited liability companies or limited partnerships).

Thus, while there are 44,000,000 businesses in the U.S. that file tax returns each year, probably fewer than ten percent of them have non-owner employees.

The 24 million or so enterprises categorized as true businesses have about 20 million owners, of whom about 9.4 million of those owners receive 25% or more of their income from their small business (the "narrow" definition of small business owner).

There are 7,452,000 people who are shareholders or partners in entities taxed as partnerships or S corporations that constitute more than de minimus businesses (excluding spouses where both husband and wife are partners or shareholders in an entity). But, only 5,321,000 of them have active income or losses from a small business, and only 2,305,000 of them have active income or losses from a small business with employees (which in a signficant number of cases simply represents owner-employees of S corporations). The others are either owners of big businesses, rather than small ones, or have only passive income from the enterprise which is an investment rather than a vocation for them.

Most prior tax statistics, due to a lack of data, have greatly overstated the number of business returns that represent small businesses as we conventionally think of them. A great many businesses are vehicles for passive or occassional investors, and a great many small business owners are passive investors.

A significant number of typically closely held business forms typically associated with small businesses are actually "big businesses" with an alternate form of organization for tax purposes. The exclusion of big businesses from statistics related to "small business" based upon entity type, materially reduces the amount of business activity that is fairly characterized as coming from the small business sector and greatly diminishes the extent to which tax increases for high income taxpayers has an impact on small business. About 32% of a broad definition of "small business" income (and 29% of a narrow definition of "small business" income that includes only income from small businesses that makes up 25% or more of a small business owner's total income) is taxed at the 33% or 35% marginal tax rates; while about 86% of the business income of big businesses not structured a C corporations is taxed at those rates.

Big business income of about $220 billion in 2007 made up about a third of the taxable income attributable to non-C corporation businesses significant enough to be classified as businesses (the other two-thirds being "small business income").

The number of business owners who obtain active business income from small businesses signficiant enough to have employees other than the business owners themselves is quite modest, on the order of 3-4 million. In contrast, the typical business return represents self-employment but not a "firm" in the economics sense.

The Details

De Minimus Business Activity

Many business returns involve de minimus business activity or 1099 labor performed for another firm, or incidental rental activity of personal assets, that doesn't really amount to a full fledged business. In this category it found: 12,491,000 sole proprietorships, 5,043,000 Schedule E filers (e.g. rental income), 1,095,000 Schedule F filers (farm income), 797,000 partnerships, 2,000 S corporations and 1,000 C corporations.

Big Business

It also excluded "big businesses" with $10,000,000 or more of income at the enterprise level. This involved 5,000 sole proprietorships, 1,000 Schedule E filers, less than 500 Schedule F filers, 68,000 partnerships, 92,000 S corporations and 75,000 C corporations (about 246,000 big businesses in all).

This left as genuine "small businesses" 10,679,000 sole proprietorships, 4,592,000 Schedule E filers, 1,415,000 Schedule F filers, 2,232,000 partnerships (including entities taxes as partnerships like LLCs), 3,462,000 S corporations, and 1,563 C corporations.

Only a subset of these genuine small businesses had employers: 1,659,000 sole proprietorships, less than 500 Schedule E filers, 126,000 Schedule F filers, 553,000 partnerships, 1,760 S corporations and 864,000 C corporations. The number for S corporations and C corporations probably includes many employee-owners with no other employees who take wages rather than profits for tax reasons.

Partners and S Corporation Shareholders

Partnerships and S corporations partners or shareholders. There are 1,952,000 partners with active business income or losses from small business partnerships and 3,369,000 shareholders with active business income or losses from small businesss corprations. There are 1,855,000 partners with passive business income or losses from small business partnerships and 436,000 shareholders with passive small business income or losses from S coorporations.

There are 452,000 partners and 199,000 S corporation shareholders with active business income or losses from big business partnerships and S corporations. There are 508,000 partners and 66,000 S corporations shareholders with passive business income or losses from big business partnerships and S corporations.

In partnerships that are employers, there are 591,000 partners with active income in small businesses and another 193,000 partners with active income in big businesses. In S corporations that are employers, there are 1,714,000 shareholders with active income in small businesses and 170,000 shareholders with active income in big businesses.

In partnerships that are employers, there are 186,000 partners with passive income in small businesses and another 119,000 partners with passive income in big businesses. In S corporations that are employers, there are 226,000 shareholders with passive income in small businesses and 59,000 shareholders with passive income in big businesses.

READ MORE - IRS Classifies Businesses As Big Or Small

Closely Held Public Companies

The stereotypical publicly held company has few, if any, of the people who provided the company with cash in exchange for equity still on its shareholder rolls, have few shareholders who hold blocks of stock even as big as 5%, would need hundreds or thousands of shareholders to agree simply to secure a majority in interest in a shareholder vote, have a board of directors that is effectively self-perpetuating and owes its allegiance primarily to senior management, and have investors who are mostly operating according to the "Wall Street Rule" of selling shares in companies that are ill-managed rather than trying to reform the company by influence members of its board of directors. Institutional investors in these companies generally choose to provide a rubber stamp to management rather than expressing opinions on management issues, in part, out of fear of the securities law implications of doing so.

The famous separation of ownership and control in this companies is at the heart of the criticism of American corporate governance which is prone to excessively compensating senior executives, providing senior executives with poor incentives that can encourage systemic risk in the economy as a whole, and not holding mediocre management teams accountable for their suboptimal management of their companies.

But, this isn't description isn't a good match to an important subgroup of public companies which I oxymoronically call "Closely Held Public Companies." A new Pennsylvania State University College of Business Administration study entitled "Are Busy Board Detrimental?", looks at the subclass of newly public companies whose IPOs were launched by venture capitalist firms.

These firms, a thousand of which are reviewed, don't fit the stereotype. Almost all of the new investors either directly supplied cash equity to the company in exchange for stock (an average of $72 million each). The average seven board members own or control 33% of the stock of these companies, and the average "busy" board member, defined as serving on three or more board, has an investment of at least $5 million in the company. The typical board has four venture capitalist firm executives (who disproportionately serve on audit and compensation committees and as chairmen of the board), two insider executives who are directors, and one other outside director (who two-thirds of the time serves on no more than one other board and usually serves on that board of directors alone). The board membership was typically determined by an investment bank that took the company public, a venture capital firm, and senior management in a negotiated effort to please IPO investors. Typically, a few dozen shareholders control a majority in interest of the company's shares and even the big investors who do not have directorships know each other personally. The senior management team, rather than being appointed by the board after a talent search, is typically the group of individuals whose efforts as managers grew the business until it could be attractive enough to outside investors to go public. The venture capital firms that own a large share of these newly public firms have a business model that calls for active management of the newly public firms for at least a medium term time frame (ca. 3-5 years at least), in order to continue to grow their hands on, long term investment in active indirect management of the company so it can thrive, as do the employee-owner senior managers who usually expect to spend at least as many more years running the firm that they took public.

While these firms are nominally publicly traded because they have made a public offering of securities and have some small time passive investors, their governance arrangements are more like closely held private companies with significant non-employee investors, than they do like stereotypical publicly held companies. Most importantly, they do not have a meaningful separation of ownership and control.

So, while the study purports to ask if "Busy Boards" are detrimental, the confounding variable in the study is very strong director financial interest in the venture upon which the director serves and generally good corporate governance standards of new VC launched IPOs, avoid the criticisms of busy boards raised with more established firms.

The 95% of the directors of these firms aren't really busy they have day jobs that include being a director, either incident to their role as a venture capital firm executive, or incident to their job as a senior executive of the board's firm, or because they serve on only one board, or because they don't have a day job for some reason. Only 5% or less of the directors of these firms (just 20% have even one such person) are outsiders who aren't VC executives who serve on three or more boards and have a day job as well, and the world does still have a few overachievers left who can somehow handle that burden gracefully, and if they can't, they have six other board members who can pick up the slack.

Thus, busy directors seem like a non-issue in this study mostly because the term was defined in an inappropriate way that disregards the nature of the director's day job, and because the governance positives in these closely held public companies overwhelm any governance negatives that may flow from having busy directors. Not surprisingly, indicators of accountable management, like lower than average CEO pay and higher than average company performance are typical of these newly public companies.

The serious corporate governance problem in the American economy is not with newly public firms that have just completed IPOs, but with firms whose long term investors have sold their shares, whose initial dynamic management team has been replaced by executives chosen in interview rather than exceptional performance building this very business, whose highly financially interested venture capitalist directors and insider directors have been replaced by toadies of the new management team with a weak financial interest in the firm's performance, and whose new institutional investor owners have abdicated a role as active supervisors of the senior management team, in part because corporate and securities law discourages this, and in part because this isn't a part of their business model. Once this stereotypical separation of ownership and control takes hold, pressure on management to refrain from self-dealing and perform or be replaced is gone. The new focus starts to center on providing an unattractive target to hostile takeovers by means unrelated to actual financial performance and on growing the scale of the business without regard to profitability, because scale rather than profitability or management performance, drives the ability to pay senior executive compensation in these firms (for which cash flows are great enough to sustain large executive pay packets even when the company is doing poorly).

Typically, once a firm gets its initial infusion of IPO equity, retained earnings and corporate bond offerings, rather than new equity offerings, are the main sources of new capital for the firm, except at points in the business cycle where the company is performing well and appears to be overvalued in the long run, allowing it to secure a rare major new infusion of equity from the public with a modest number of shares. Since it generally doesn't need shareholders to raise new capital, can get away with not giving shareholders any meaningful role in the appointment of its board of directors or executive compensation, and can discourage hostile takeovers with poison pills and other barriers to changes in control and ownership even when it would make economic sense in the absence of those self-created barriers, these firms can get away with giving shareholders very little and the pressures from above on senior management are far too weak to be optimal.

The most visible symptom of this governance problem is the overcompensation of self-dealing senior executives. But, the deeper issue that matters more to the economy is the opportunity cost associated with lax ownership permitting mediocre executives who always are at the held of some share of big businesses to managing the assets of big business less well than another management team that knew that it would be held accountable for its performance could. Since large, publicly held companies make up the vast majority of economic activity and employment in the United States, even a modest subset of poorly managed big businesses are a critical problem for the health of the American economy as a whole.

The solution is to find ways to well established large publicly held companies to act more like the closely held public companies whose IPOs have just been launched by venture capitalist firms.

* Control needs to be vested more firmly in institutional investors with strong financial incentives to do so, who take the kind of interest in and have the expertise in monitoring and holding accountable the senior management team in performance, compensation and transparency, are capable of the kind of collective ownership action, and invest at least for the medium term in the way that venture capital firms do. The biggest barriers to this are (1) in the proxy rules for nominating director candidates and information about them, and getting this on a ballot sent to all shareholders (the current norm is a Soviet style director's ballot), and (2) in the securities laws that could construed collective shareholder action as some form of securities law violation or other civil wrong.

* Publicly held companies need to have incentives to left shareholders, rather than senior management, decide how to reinvest profits from the firm. Further, the tax and corporate law incentives that favor debt over equity, which increase systemic risk during recessions, need to go, if effective shareholder governance is possible. Securities law plays a role here as well. Equity holders can bring securities fraud suits when stock prices suddenly plunge as a result of the late disclosure of material information about a company. Debt holders can bring securities fraud suits, in general, only when the company defaults, and by then it has usually declared bankruptcy and there is nothing to collect out of in a securities fraud action once the bankruptcy is complete. So securities fraud liability analysis favors debt financing over equity financing.

* Public companies need to have at least a balance between incentives to split up and incentives to merge, in both the tax law and in corporate governance practice (e.g. executive compensation practices) so that companies do not grow big simply for the sake of being big. We need to remove systemic incentives to become too big to fail and to unduly concentrate the market with fewer bigger firms (even when this doesn't mean that a firm has a monopoly or near monopoly in any given product market).

* The law needs to discourage poison pills and other barriers to hostile takeovers that prevent the market from disciplining poorly performing firms. For example, it needs to end the race to the bottom choice of law rules that make management friendly Delaware corporate law the norm on corporate governance issues. It may be most sensible to simply require that all publicly held companies have their governance conducted according to a federal corporate code, rather than state law, with Congress acting pursuant to its commerce clause powers, given the indubitable interstate commerce impacts of federal corporate law, which securities laws have already effectively taken control of in many important respects.

The market is stumbling in a Coasian way towards this end.

* Greater leverage prevents profits from being entirely reinvested in the firm even if it is suboptimal to do so, holds management accountable to minimum performance measures, is easy for investors to monitor and act collectively on behalf of, minimizes the kinds of disclosures that materially impact the value of the assets in light of information asymmetry, and uses principal payments to force borrowing companies to continually renegotiate the terms of their financing in order to continue to operate.

* Going private transactions remove the debt-equity imbalances that face publicly held companies and permit the more functional corporate governance regime of privately held companies to apply.

* Pre-packaged bankruptcy plans and corporate auctions facilities with bankruptcies allow overleveraged companies to survive economic downturns by sacrificing some share of long term subordinated and general bond creditor's investment.

But, the measures cobbled together in the private sector under current law are half measures that still leave big business much less well governed than it should, and successful reform is necessary for the long term prosperity of the American economy.

READ MORE - Closely Held Public Companies

The Tax Code's Merger Ratchet Drives Harmful Economic Decisions

Corporate tax law students, but very few other people, spend vast amounts of their time learning how to understand the Internal Revenue Code's corporate reorganization provisions. Being tax law, this task leaves you knee deep in detail and you can lose the forest for the trees. But, in the big picture, the corporate reorganization provisions of the tax code may do more to encourage our economy's tendency to create systemically risky too big to fail businesses that interfere with consumer friendly competition than our antitrust laws do to discourage them.

Simply put, there are lots of relatively easy, safe harbor ways under the tax code to merge a business with predictable, favorable tax consequences. There are "A" reorganizations (statutory mergers), there are "B" reorganizations (stock for stock purchases of companies), there are triangular "B" reorganizations (stock for stock acquisitions by a parent company that merge the acquired company directly into one of its subsidiaries), there are "C" reorganizations (stock for asset purchases of companies), there are triangular "C" reorganizations (stock for asset acquisitions by a parent company that merge the acquired company directly into one of its subsidiaries), and there are acquisitive "D" reorganizations (another flavor of stock for asset purchases of companies). (Reorganizations are usually classified by the lettered subsection of Internal Revenue Code Section 368 that authorize them). There are also some lesser known back door ways to merge companies, such as via a contribution to capital of a sister corporation by its shareholders.

In contrast, obtaining the same kind of favorable tax treatment for divisive reorganizations (also called "D" reorganizations), which can be structured as spin-offs, split-offs, or split-ups, are fraught with tax risk and uncertainty. The IRS and tax lawyers have to pay close attention to regulations that have detailed facts and circumstances driven analysis, and a great deal of audit and pre-approval efforts to making sure that tax code requirements regarding which assets can go in which surviving corporation are met.

In a divisive tax free reorganization, like a tax free merger, nobody leaves either kind of transaction with untaxed cash at closing (although for publicly held companies the difference between stock and cash may not be all that material since anyone who wants to can readily sell their stock for full fair market value at a moment's notice and tax free, hard money margin loans are widely available if the stock is not sold), in an effort to prevent potential leaks in the regime of double taxation of corporate profits that is criticized by big business executives and liberal academics alike under our tax code.

But, our tax code discourages publicly held companies from splitting by with the frequently deal busting risk of unexpected premature taxation of all of a successor company's assets. Divisive reorganizations will often prove unworkable from a tax perspective unless the groundwork for the move is laid years in advance and even then, the freedom of businesses to split themselves up into units that make the most economic sense can be materially limited by the need of lawyers and accountants involved in the deal to control tax risk.

As a result, mergers of publicly held corporations are relatively common place, while divisive reorganizations, like the one announced by Kraft today that breaks its business into an internationally oriented snack food business and a domestically oriented grocery store product business, or the recently announced deal to unwind the merger of Wendy's and Arbys restaurants, are the much more rare and notable exceptions.

This little known bias in the tax code, at the macroeconomic level, gives us too many conglomerates, in which it is hard for stock market price discipline to hold management accountable and which create systemic risk in our economy that flows from too big to fail entities (like AIG), while discouraging the financial markets from crafting firms in a way that disaggregates separate businesses from each other to the full extent that their underlying lack of economic interdependence permits.

The merger bias in the tax code also harms the economy by reducing transparency in financial disclosures. The SEC has exacting rules on financial reporting for publicly held companies, but one of the big shortcomings of those rules, that prevents the financial markets from efficiently allocating capital to profitable businesses, while denying further resources to businesses with poor profits, is that the financial accounting rules do little to require the divisional and line of business breakdowns of corporate profits, losses, assets and liabilities necessary to do the managerial accounting analysis necessary to determine if corporate restructurings make sense.

Instead, the combination of weak subunit reporting requirements from the SEC, corporate reorganization taxation biases against divisive reorganizations, and a double taxation of corporate profits regime that encourage businesses to retain earnings from equity to reinvest in their own company even when the average stock market investor would agree that the funds would be more profitably reinvested in some other segment of the economy, all conspire to increase systemic risk in our economy, reduce transparency in our financial markets, and inefficiently allocate financially investments to business divisions that are suboptimal uses of available capital.

Indeed, the bias towards reinvestment of corporate earnings, coupled with the bias against divisive reorganizations, creates an incentive that is strongest for the least well managed businesses to acquire better run businesses that throw off cash for the primary purpose of obscuring their weak performance and diverting the cash from the successful businesses towards reinvestment in poorly run businesses.



Our economy relies on the threat of hostile takeovers by businesses who can profit by identifying mismanaged companies, buying them, jettisoning the bad management or reversing bad decisions, and improving the bottom line as a result to hold corporate executives accountable and to give them an incentive to manage their companies effectively. But, conglomerates with many units purchases to provide internal access to retained earnings that lack meaningful public disclosure of unit performance that would be available if the divisions were separate publicly held firms, discourage this kind of market discipline, as do management friendly rulings of the Delaware courts that allow publicly held corporations to discourage market efforts to hold them accountable with golden parachutes that international financial experts have widely condemned as encouraging systemic risk by rewarding senior executive mismanagement, and other poison pills to discourage shareholder and financial market identification of and intervention to end mismanagement of big businesses.

In theory, antitrust laws should prevent anticompetitive mergers that harm the public interest, but in practice, they are a toothless tiger than looks impressive but has little practical impact. Most of the harm from a bias towards mergers and against holding separate functional business units accountable flows from the collective effect of little incremental decisions whose public impacts are not obvious. By the time that antitrust regulators can truly prove that the merger of the last few oligarchic firms in an industry will harm competition, the damage has already been done, and nothing gives antitrust authorities the power to limit the formation of conglomerates that don't have monopoly power in any one industry, despite the fact that this was one of the concerns that led to the passage of these laws in the first place.

Collectively, these incentives and corporate and antitrust law flaws have not only negative economic efficiency consequences, but negative consequences for the appropriate distribution of wealth and income in society and the allocation of political power. While economically unreasonably large firms may not necessarily have unreasonable market monopolies in given industries, their sheer size does unreasonably concentrate wealth in a self-dealing economic elite of senior managers and the top professional advisers in investment banks, law firms and accounting firms (for example), and similarly, unreasonably concentrates political power in these unaccountable elites, while providing a means by which businesses have an incentive to fight for the interests of this economic elite as a social class, rather than being disaggregated into the conflicting factions of smaller firms with more particular political interests that the founders envisioned in the Federalist papers that are more easily subjected to the diffuse interests of the majority. In a nutshell, conglomerates encourage logrolling and mutual backscratching not just by politicians themselves but by the monied interests that are developing political coalitions that work to the detriment of the public interest.

Is this a lot to lay at the foot of Internal Revenue Code 368, corporate double taxation, and regulations promulgated by the IRS and SEC? Surely it is. But, the obscure pieces of our regulatory framework conspire to drive the unreasonable concentration of economic power, wealth and income, while simultaneously making our economy less competitive. They may not be flashy, but their day after day, broad systemic impact on the way that decisions are made in the dominant sector of our economy have a cumulative impact that is easily underestimated.

READ MORE - The Tax Code's Merger Ratchet Drives Harmful Economic Decisions

SCOTUS Win For Janus Capital

Janus, a Denver based mutual fund group with its headquarters across the street from the Cherry Creek Mall won a major victory in the U.S. Supreme Court today. In the group, different mutual funds are organized as separate legal entities owned by their investors, and each fund has a management and control arrangement with the master entity. The ruling was a 5-4 decision for Janus along the usual conservative-liberal lines with the conservatives prevailing.

One of the funds made a statement in a prospectus that gave rise to securities fraud liability. The issue was whether the master entity could be held legally liable for the statement made only in the name of the individual fund because it provided management services and had effective control of the entity. Continuing a trend of the U.S. Supreme Court to limit secondary liability for securities fraud (e.g. disallowing aiding and abetting liability in private securities litigation), the court ruled that only the fund was legally responsible for the mistatement made in its prospectus about its fund. As a result, the damage is confined to a single entity and since there is substantial identity between the people hurt by the misstatement and the owners of the fund, the amount of financial gain available to the people bringing the suit may be modest.

The fund might have legal recourse against the master company for a breach of duty in the management of the fund that caused the misstatement to be made and caused the fund to incur liability, but given the pervasive control of that relationship by the master company, it is unlikely that such a suit will be brought in the absence of a derviative action (i.e. a suit against a third party in the name of the company brought by the owners of the company because the company itself refuses to act) by the fund owners, and such actions rarely prevail. The U.S. Supreme Court ruling, however, means that in this and many similar arrangements, the master company will have no liability for statements made in the name of a mere fund in a prospectus.

Essentially, the U.S. Supreme Court held that involvement in ghost writing a document does not suffice to pierce the corporate veil for private securities fraud lawsuit purposes.

READ MORE - SCOTUS Win For Janus Capital

U.S. Corporate Income Taxes Lowest In OECD As Share of GDP

The United States is the OECD country with the lowest corporate income taxes as a share of GDP (1.8%) in 2008, despite the fact that it has one of the highest marginal corporate income tax rates.  The paradox is a result of the fact that there are more generous tax credits and tax deductions in the American corporate income tax than in foreign corporate income taxes.  U.S. law generally permits corporations to take tax deductions for capital purchases much more quickly than over the useful life of the purchase and has a generous deduction for research and development expenditures, for example.  The OECD average is almost twice as much as the tax burden in the United States. 

Critics of the importance of this ranking argue that this is mostly a result of shrinking corporate profits following the financial crisis, a crisis that hit the U.S. harder than it did big businesses in other countries.  But, it is hard to argue that the global economy didn't itself take a global hit in 2008.

Another complication in comparing corporate income taxes internationally is that publicly held U.S. corporations generally pay corporate income taxes, then distribute a large share of the after tax profits as dividends and pay individual income taxes on the distributed profits (albeit at a reduced top marginal rate).  In contrast, most countries tax distributed profits either only at the corporate level or only at the individual level.  Thus, the total taxation of corporate income is really somewhat higher than it seems looking at corporate income taxes alone, relative to other countries.  (The magnitude of this effect is small enough, however, that it would still leave the U.S. near the bottom of the OECD and very close to Germany.)  

On the other hand, many closely held entities that pay no corporate level tax in the United States because they are limited liability companies taxed as partnerships or S corporations would pay significant corporate level tax (which would be charged against individual level taxes) in much of the world.  If all of the individual income tax attributable to closely held limited liability entities in the United States were treated as corporate income tax revenue rather than individual income tax revenue in international comparisons, the size of the corporate income tax revenue flow would be significantly higher.

The bottom line, of course, is that it is easier to compare overall tax burdens between countries than it is to compare the burdens of particular taxes, because structural features of different tax regimes can make it appear that there are big differences between tax regimes for accounting purposes that have little economic relevance.

Still, none of these factors are sufficient to support the assertion that U.S. corporate income tax burdens make the U.S. uncompetitive in international business and cost it jobs, which is essentially the argument made by those arguing for lower marginal corporate income tax rates in the United States. Indeed, U.S. international competitiveness seems to be greater for publicly held corporations that are subject to these tax rates than for closely held businesses that have more favorable tax treatment. The U.S. small and medium sized business sector is notably weaker than its foreign competition, while its big business sector is fairly robust.

READ MORE - U.S. Corporate Income Taxes Lowest In OECD As Share of GDP

Corporate Taxes Are The Exception

According to the IRS in 2008 there were 6,349,720 for profit corporations in the United States. These come in several types.

Pass Through Corporations

Some don't pay income taxes at all and are pass through entities:

S corporations: 4,292,433 (of which 4,049,944 are active)
Form 1120 RIC filers: 13,081 (mutual funds with pass through taxation)
Form 1120-REIT filers: 1,650 (real estate investment trust with pass through taxation)

The active S corporations have, in the aggregate, 6,930,746 shareholders (an average of 1.71 shareholders each). Of the active S corporations, 2,493,706 S corporations (61.6%) have net income; this income is allocated to 4,200,809 shareholders in those corporations (an average of 1.68 shareholders each).

While subchapter S of the Internal Revenue Code allows up to 100 shareholders as of 2004, (and really more, due to the nature of the counting rules) to be shareholders in S corporations, in practice, this is very rare and there is little grass roots pressure to increase the limitation. As of the 2007 tax year, when there were 3,989,893 active S corporations:

2,411,642 had 1 shareholder (60.4%)
1,163,717 had 2 shareholders (29.2%) (thus, 89.6% had 1 or 2 shareholders)
200,183 had 3 shareholders (5.0%) (thus, 94.6% had 1-3 shareholders)
188,531 had 4-10 shareholders (4.7%) (thus 99.4% had 1-10 shareholders)
14,481 had 11-20 shareholders (0.4%)
4,575 had 21-30 shareholders and (0.1%)
3,764 had 31 or more shareholders (0.1%)

Most of the S corporations with 31 or more shareholders are either in the business of accomodations and food service (802) (about 0.4% of S corporations of that type) or "Management of Companies" (1,076) (about 4% of S corporations of that type).

Excluding single owner S corporations, the average number of shareholders per S corporation would be about 2.8 per corporation, which is still fewer partners than any type of entity taxed as a partnership under subchapter K.

In the five year period, total number of active C corporations is down about 15% and the total number of S corporations is up by about 20%.

C Corporations

Others are taxed under the C corporation regime, in some cases with significant modifications:

Ordinary C corporations: 1,995,828 (of which 1,762,483 are active)
Form 1120-F filers: 30,549 (foreign corporations that do business in the U.S.)
Form 1120-PC filers: 7,482 (property and casualty insurance companies)
Form 1120-L filers: 736 (life insurance companies)
Other Corporations: 7961 (mostly from U.S. territories and possessions)

In addition to the 30,549 foreign corporations that must file Form 1120-F, there are 66,797 domestic C corporations that are 50% or more foreign owned. S corporation status is not available for corporations with foreign shareholders.

Of the latter group, there are 1,782,478 active corporations (mostly ordinary C corporations and another 19,997 from other types). Inactive corporations had no taxable income or expenses, but are required to file tax returns in any case.

Of this group of active corporations, 935,939 corporations (52.5% of active corporations that are subject to corporate income taxes) had no net income (i.e. they either broke even or experienced a tax loss), while 846,540 had net income.

Of the 846,540 with net income, 544,331 owed corporate income taxes before credits, and 533,386 owed corporate income taxes net of credits. Thus, just 29.9% of corporations that are subject to corporate income taxes actually owed any corporate income taxes in 2008. Another 17.6% of corporations that are subject to corporate income taxes had net income but owed no corporate incomes taxes for one reason or another (e.g. loss carryforwards and tax credits).

Of the corporations owing any corporate income tax, 360,457 paid less than $6,000 of corporate income tax (all of which is subject to the 15% corporate income tax bracket). These corporations accounted for about 0.3% of all corporate income taxes owed, and for 67.6% of all corporations that owed any corporate income tax.

Another 77,640 corporations owed more than $6,000 but less than $15,000 of corporate income tax, and almost all of that income would have been taxed in the 15% or 25% corporate income tax brackets (which end at $13,750 of tax owed). These corporations account for 0.3% of all corporate taxes owed, and for 14.6% of corporations that owed any corporate income tax.

Thus, 82.2% of corporations that owed any corporate income taxes owed just 0.6% of corporate income taxes owed. (Note that this doesn't necessarily mean that the corporate income tax has no tax revenue effect in these cases, it simply means that it created an incentive to convert most corporate income into taxable compensation in many cases.)

Another 60,055 corporations (11.3% of corporations that owe corporate income taxes) that owed less than $100,000 of corporate income taxes (and thus owed some corporate income taxes in the 34% corporate income tax bracket but received some benefit of the lower 15% and 25% marginal tax rates for corporations before they were fully phased out at $133,900 of taxes due), owed 1.1% of all corporate income taxes.

Thus, 93.5% of corporations that owed any corporate income taxes owed less than 2% of all corporate income taxes.

The 370 corporations owing more than $100 million in corporate income taxes in 2008 owed 64.8% of all of the corporate income taxes owed by all corporations in that year. The next 1,642 corporations (those owing $10 million to $100 million in corporate income taxes in 2008) owed 21.3% of all of the corporate income taxes owed by all corporations in that year. Thus, the 2,012 corporations with the biggest tax bills owed 86.1% of all corporate income taxes. All of this corporate income is taxed at a flat corporate income tax rate of 35% (bubble rates eliminate the benefit of graduated tax rates at lower incomes for these corporations).

In between, there were 37,221 corporations that owed $100,000 or more of corporate income taxes but less than $10,000,0000 of income taxes, overwhelmingly taxed at an average rate of 34% to 35%. The 34% rate is fully phased in at $113,900 of tax owed and the 35% rate is fully phased in at $6.417 million of tax owed. The owe 12.7% of all corporate income taxes.

Thus, 39,232 corporations owe 98.8% of all corporate income taxes, despite being just 0.6% of all corporations required to file an IRS Form 1120, while 91.7% of all corporations required to file an IRS Form 1120 of some kind owe no corporate level federal income taxes. The 1.2% of corporate income taxes paid by the remaining 7.7% of corporations is mostly paid in the 15% or 25% corporate income tax brackets, which can provide tax deferral or reduction to shareholders in the 35% individual income tax bracket that would apply to a pass through entity. In addition, C corporation dividends are not subject to FICA or self-employment taxation, and qualified dividends and long term capital gains from these entities are subject to tax rates of 15% or less.

Entities Taxed As Partnerships

In 2003, there were also about 19 million sole proprietorships and there were "2.5 million businesses in the United States taxed as partnerships with 15.6 million partners, an average of about six partners each":

About 402,000 are limited partnerships (i.e. those with both general and limited partners), with an average of 17 partners each, disproprtionately in the finance and insurance area, and to a lesser extent in the real estate, rental and leasing industries. About 725,000 are general partnerships (i.e. those in which all partners have unlimited liability), with an average of 3.7 partners each. About 1,270,000 are limited liability companies, with an average of 3.9 partners each. About 150,000 are some other form of entity taxes as a partnership (one suspects that limited liability partnerships and limited partner assocations would be in this category, for example), with an average of six partners each.

None of these entities taxed as partnerships owe entity level federal income taxes.

Updated partnership data is available from the IRS. In 2008 there were 1,898,178 LLCs taxed as partnerships (about half in real estate, rental and leasing; 948,862 LLCs with 3,533,512 partners), up about 50% from five years earlier, with 7,524,174 partners (an average of 3.96 each). Some of the largest LLCs, measured by numbers of owners per LLC on average, are in finance and insurance, with 147,327 LLCs and 1,055,783 partners (9.2 each on average). Outside these two industries, the average LLC has 3.6 partners.

In 2008, there were 669,601 general partnerships with 2,623,041
partners (3.9 partners each on average), a drop of about 7% over five years, and 411,698 limited partnerships with 7,054,319 partners (17.1 partners each on average), an increase of about 2% over five years.

Of the general partnerships, 238,586 general partnerships with 925,616 partners were in the real estate, rental and leasing industry, while 74,185 general partnerships with 467,033 partners were in the finance and insurance industry. These industries accounted for about 35% of general partnerships and 53% of general partners. Outside these industries, the average general partnership has about 3.5 partners.

The limited partnerships were concentrated in real estate, rental and leasing (246,760 limited partnerships and 2,048,474 partners) and finance and insurance (77,622 limited partnerships with 2,017,856 partners); the two industries account for almost four-fifths of limited partnerships and almost three-fifths of the partners in limited partnerships. Also notable is the industry of transporation and warehousing that has 1,510 limited partnerships with 1,107,494 partners (an average of 733 partners each).

In the 2008 tax year, there were 3.3 million partnership tax returns filed (up more than 30% over five years), a number that is more comparable to the active corporation numbers than the total corporation numbers because inactive partnerships are not required to file income tax returns, while inactive corporations are required to file income tax returns.

Non-Profits

The IRS identifies 1,855,067 non-profit entities that owed no corporate income taxes in 2008, the vast majority of which are organized under Internal Revenue Code Section 501(c), with the vast majority of those being organized under 501(c)(3). There were 901,000 exempt organization tax returns filed in 2008.

Other Entity Types

There were also 3,075,000 estates and trusts that filed tax returns in 2008. There were 30,683,000 employment tax returns filed in 2008, which would include many sole proprietors with employees but would exclude many business entities without employees.

Managerial Variety

For all the myriad choices of entity, there are basically three kinds of ownership structures that are dominant in the United States today.

One is an active closely held business with just a handful of owners who operate largely by consensus.

A second is an essentially passive investment portfolio of either physical assets or financial investments with a medium sized group of investors who are expected (or required) to be largely passive and to defer to a handful of active managers whose shared incentives they rely upon to assure sound management of their investments.

A third is the publicly held corporation, where, in practice, senior management appoints a board of directors that intervenes only in cases of succession crisis or managerial insanity or corporate takeovers, which is largely indifferent to shareholders whose voting rights are basicallly worthless outside a takeover event.

Closely held active businesses with more owners than you could fit around a medium sized conference table (perhaps a dozen to a few hundred), who are involved enough to make considered votes for members of a genuine shareholder representing board of directors, that in turn independently supervises a managerial group on behalf of the shareholders, are very rare in the for profit sector, despite the fact that this is the model for the typical American state corporation statute and is common in the governmental and non-profit sectors.

The typical business that operates on this basis is either a large professional services firms, such as a law firm or accounting firm in which owners are also mostly full time employees of the firm, or is a cooperative, rather than a partnership, or an ordinary corporation. The co-operative business form is discussed in a footnote below.

Choice of Entity

S corporations are attractive because they provide a clear way to reduce FICA taxation, have simpler to comply with tax rules for non-tax experts than limited liability companies, and are consistent with the economic arrangement that many small business owners want. They are a particularly attractive choice for operating businesses without appreciating assets. In contrasts, businesses that primarily own property, particularly if it is likely to appreciate, and businesses that do not qualify to be S corporations due to foreign ownership or complex financial arrangements between co-owners but want pass through taxation treatment favor limited liability companies taxed as partnerships or as disregarded entities. Most new closely held businesses are organized as S corporations or LLCs.

Limited partnerships are chosen over limited liability companies mostly as a result of tradition in certain kinds of investments and because they are the only type of entity that deprives economic owners of almost all voting rights. Limited liability partnerships are typically chosen by professional service partnerships previously organized as general partnerships, to minimize the amount of transition legal and tax work required. General partnerships are usually either chosen by default without counsel, or are between entities or individuals for whom legal liability is not a concern but the ability to fully utilize losses is a concern, since the taxation of unlimited liability general partnerships is simpler than the taxation of limited liability entities taxed as partnerships. Only about a quarter of entities now taxed as partnerships have unlimited liability.

A few state and local jurisdictions (mostly if not entirely in the Northeast) tax S corporations and/or limited liability companies at the entity level, making these choices less attractive and zeroed out C corporations more attractive.

As discussed further below, C corporations are attractive for the anonymity they offer, the fact that one only owes taxes on transactions that produce cash flow for the person taxed (something that venture capitalists often like as a feature), because special tax breaks are available for capital gains in these entities in some circumstances, in some cases for employee benefits reasons, in some cases because they afford low marginal tax rates to high income individuals, and in cases where there are foreign owners, a company is publicly held, or for some other reason no other entity choice is available. One a corporation is a C corporation and has accumulated earnings and profits that have not been distributed as dividends, the tax cost of converting to another form of entity can be great, so many older closely held companies are organized as C corporations out of inertia.

In the current tax environment there can be tax benefits to having C corporations that actually pay corporate level income taxes.

The combination of a 15% entity level corporate income tax and a 15% tax on qualified dividends or long termm capital gains is equivalent to a 28% income tax rate and is FICA free. So, a small amount of entity level taxation produces lower aggregate income taxes than pass through taxation for an individual in the top 35% federal income tax bracket, and with FICA and self-employment tax considerations can also produce lower total taxes for someone in the next lower 25% federal income tax bracket who would otherwise have been subject to the Medicaid portioon of FICA or self-employment taxes.

The combined tax burden on income taxed 25% corporate tax bracket is equivalent to a pass through tax rate of roughly 46%, which is more than the top federal income tax bracket of 35%, but it can mitigate the Medicaid portion of FICA or self-employment taxation, which is almost six percentage points, can allow owner level income earned in a state with a high individual income tax rate to be deferred until the owner moves to a state with little or no individual income taxes, and may even allow the owner to avoid individual level income taxes entirely by holding onto the stock until death when unrealized capital gains taxes are forgiven with the stock liquidated by the individual's heirs. Also, even if there will eventually be a shareholder level tax, taking a tax of 25% immediately rather than 35% immediately can free up cash flow to reinvest in the company providing a tax deferral benefit and a low cost form of business financing in a growth business.

Analysis

More than 98% of entity level federal income taxes are owed by fewer than 40,000 large C corporations (with the lion's share of those taxes coming from publicly held entities) out of more than 30 million businesses and non-profit organizations in the United States. Corporate level income taxation is the exception rather than the norm.

For the other 99.4% of corporations, the primary purpose of the corporate income tax is to create an incentive to discourage corporations from accumulating corporate level earnings that are not taxed on a pass through basis in a form that prevents them from being taxed at the shareholder level when earned. The pattern observed strongly supports that theory that the vast majority of corporations of any economic consequence act rationally to minimize combined owner-entity level federal taxation through choice of entity and management of compensation arrangements, except in cases where foreign ownership that desires to receive a return on its capital, or the need to have a large number of equity investors to finance the venture makes this effectively impossible.

About 7.7 million business entities are taxes on a pass through basis as S corporations, partnerships, RICs or REITs, and another 4.9 million economic entities are non-profits, trusts or estates that either owe no entity level tax or have the capacity to shift entity level taxation to beneficiaries in a way that would eliminate double taxation.

Of the 1.8 million C corporations, about 70% are "zeroed out" C corporations that owe no entity level corporate income tax after tax credits, and the vast majority of the tax paying C corporations with low amounts of corporate income tax owed appear to choose this form of organization because they benefit from progressive marginal tax rates for low income C corporations either as a form of partial tax deferral or as a means of reducing aggregate tax burdens. "Zeroed out" C corporations have a number of tax virtues related to employee benefits, although they are increasingly marginal, and offer anonymity to owners in years when dividends are not paid. For example, they can provide a way in which individuals who do not have a social security number can operate a business and comply with relevant legal and tax laws (including a taxpayer identification number), so long as some means (e.g. overcompensation of paid employees who can work legally, who in turn financially support the true owners) is found to compensate the owners.

The broad outlines of the data from the 2008 tax year are similar to those of the 2003 tax year about which I previously posted in 2006. There are about 13,000 publicly held corporations (including all corporations with 500 or more shareholders) and about 97,000 foreign owned corporations that do business in the United States that have no choice but to be taxed as C corporations. These businesses pay the lion's share of all corporate income taxes.

Corporate Tax Integration Proposals

Many commentators have proposed to end the double taxation present in C corporations by integrating corporate and shareholder level taxation, typically by affording a deduction for dividends paid, by exempting dividends paid from individual level taxation, by wider use of pass through taxation in a simplified form, or by giving shareholders who receive dividends a tax credit that treats corporate level income taxes as a withholding tax collected in advance from funds to be distributed ultimately as dividends (the most common approach internationally). One proposal to make up the revenue that would be lost if one of these corporate tax integration options were adopted would be to impose a small annual (or otherwise periodic) tax directly upon the fair market value of publicly traded securities like a property tax, since the corporate income tax is already largely a tax on the privilege of operating as a publicly held entity, and because it would be cheap and easy to administer. These reforms would in addition to promoting fairness also reduce the debt-equity distinction that favors debt in the current tax code, which is an important factor in creating systemic risk in the economy. It would also reduce the tax bias between public and privately owned companies that now favors privately owned companies even when this is not optimal from a non-tax perspective.

Footnote On Cooperatives

In 2002, 3,140 farmer cooperatives provided marketing, farm supplies, and services to farmers. This represents a steadily declining number of farmer cooperatives, down from about 10,000 in 1950, and 6,211 in 1981. This decrease in the number of cooperatives reflects the trend of consolidation and merger occurring in production agriculture and in many segments of the food industry.

Of cooperatives operating in 2002, 1,559 primarily marketed farm products, 1,201 primarily provided farm supplies to farmers, and 380 primarily provided other services. Many cooperatives engage in two or all three of these activities.

Cooperatives can also be classified according to organization structure. Centralized cooperatives have only farmer members. Federated cooperatives have only other farmer cooperatives as members. The membership of mixed cooperatives consists of both farmers and farmer cooperatives. In 2002, 3,060 cooperatives were centralized, 53 were federated, and 27 were mixed. Just under 2.8 million producer memberships in farmer cooperatives were reported in 2002. This number includes duplications for farmers who hold membership in more than one cooperative, a common situation.

The tax treatment of patronage refunds paid to patrons and other tax implications of farmer membership affect a great number of farmer taxpayers. The gross business volume of all farmer cooperatives in 2002 was $111.6 billion, up from $90.8 billion in 1991. Marketing represented 69.0 percent of the total, farm supplies 28.3 percent, and selected services 2.7 percent. If inter-cooperative business transactions are eliminated, net business volume was $96.8 billion, up from $76.6 billion in 1991.

Most farmer cooperatives are relatively small businesses. In 2002, 83.8 percent of all farmer cooperatives reported business volume of less than $25 million.

Looking at some balance sheet numbers, combined assets of all farmer cooperatives in 2002 totaled $47.5 billion, up from $31.3 billion in 1991. Total liabilities were $27.9 billion, compared to $17.2 billion in 1991. This leaves net worth, or member and patron equity, at $19.6 billion, a sizable increase over the $14.1 billion of 1991.

The 100 largest cooperatives (the so-called Top 100 in USDA Rural Development publications) usually operate over sizable geographic areas and make up an important segment of the farmer cooperative industry. In 2002, the Top 100 accounted for $64.0 billion in business volume, 57.3 percent of the business volume for all farmer cooperatives.13 They likewise dominated the balance sheet items with $27.2 billion in total assets (57.2 percent of the total) and $8.6 billion in member and patron equity (43.9 percent
of the total).

Eighty-nine of the 100 had earnings in 2002, totaling $817.0 million. How a cooperative uses its earnings affects tax calculations of both the cooperative and its farmer patrons.

These earnings were accounted for in several ways. Cash patronage refunds totaled $194.5 million (23.8 percent). Retained patronage refunds were $394.6 million (48.3 percent). Thus $72 out of every $100 in margins realized by the Top 100 were distributed or allocated as patronage refunds. The eighty-nine cooperatives in the Top 100 for 2002 with earnings paid $74.3 million in corporate income taxes (9.1 percent). Dividends on stock amounted to $1.6 million (0.2 percent) and $152.0 million (18.6 percent) were placed in unallocated reserves.

The 11 cooperatives in the Top 100 that suffered losses in 2002 had total losses approaching $675 million. Close to $35 million was covered with tax benefits and approximately $300 million was set off against unallocated equity. The remainder is either being carried on the cooperatives’ books or being recovered from patronage equities. . . .

NON-FARM COOPERATIVES . . .

The National Cooperative Business Association reports that in the United States a network of 48,000 cooperatives directly serve 120 million people -- nearly 40 percent of the population. . . .

The largest single segment of the cooperative industry is credit
unions. The roughly 10,000 credit unions in the United States
have more than $600 billion is assets and 83 million members.

Building on their base of member savings and consumer loans and home mortgages, credit unions now offer additional services to their members including credit cards, automated teller machines, tax-deferred retirement accounts and certificates of deposit.

Created in 1916, the cooperative Farm Credit System is the nation's oldest and largest financial cooperative. It provides real estate loans, operating loans, home mortgage loans, crop insurance and various other financial services to more than 500,000 farmer, small-town resident and cooperative borrowers. It loans roughly $90 billion annually to its members.

One element of the Farm Credit System is CoBank. It has about $25 billion in outstanding loans and leases to farmer and rural utility cooperatives and water and waste disposal systems. CoBank has become an important financier of exports of U.S. farm products as it broadens its role of making credit available to enhance farm and rural income.

Since 1969, the National Rural Utilities Cooperative Finance Corporation (CFC) has been a valuable source of financing for rural electric and telephone cooperatives. With $21 billion in assets and almost $21 billion in credit outstanding, CFC supplements funding provided by USDA's Rural Utilities Service and provides business services to its borrowers. In a short period of time, the National Cooperative Bank (NCB) has become an important financial institution for America's housing, business and consumer cooperatives. Chartered by Congress in 1978 and private since 1982, NCB has originated more than $6 billion in loans to nearly 2,000 cooperatives throughout the country. NCB has become a leader in providing development funding for new, non-agricultural cooperatives and in devising methods of attracting outside capital to leverage its investments.

Nearly 1,000 rural electric cooperatives own and maintain nearly half of the electric distribution lines in the United States, cover 75 percent of the land mass, and provide electricity to 36 million people.

Roughly 270 telephone cooperatives are providing a growing portfolio of communications services to 2 million households, including wireless technology and high-speed Internet access.

More than 1,000 mutual insurance companies, with more than $80 billion in net written premiums, are owned by their policyholders.

America has about 1 million units of cooperative housing, nearly 600,000 of them in New York City. New units are being developed in many other sectors, including senior citizen communities, trailer parks, low-income complexes, and student housing near college campuses.

Millions of Americans receive basic medical care through cooperatively organized health care providers. Health maintenance organizations (HMOs) serve more than 1 million people coast-to-coast and will likely be an increasingly important part of the health care system in the years ahead. In several major cities-- Seattle, Minneapolis, Memphis, Sacramento, Salt Lake City and Detroit--companies have formed cooperative health alliances to purchase health care for their employees.

Child care cooperatives are meeting the needs of families where the parent(s) are employed and want affordable care. These centers can be organized by parents on their own, by a single employer, or by a consortium of businesses providing a single center for the group. More than 50,000 families use cooperative day care centers daily.

Some business cooperatives manufacture or otherwise procure products for their retail outlet members. For example, more than 15,000 independent grocery stores rely on cooperative grocery wholesalers for identity, brand names, and buying power they need to compete with the chains and the discounters. Members also receive training and financing. Several cooperative grocery wholesalers are multi-billion-dollar firms rivaling the largest farmer cooperatives in sales and assets.

Cooperatively owned hardware wholesalers supply virtually all of the independent hardware stores in the United States. As huge warehouse chains spread across the nation, the independents are relying more and more on TruServ, Ace Hardware, Do-it-Best, and other cooperatives for products, promotions and education to remain viable businesses.

Other business cooperatives negotiate group purchase contracts with suppliers and their members purchase the goods and services they need directly from those suppliers. A leader in this group is VHA. More than 2,200 hospitals and other health care providers purchase $20 billion annually in supplies and services under contracts negotiated by this cooperative.

Restaurant supply purchasing cooperatives save money and provide quality products for both company-owned outlets and franchisees of several fast-food chains. These firms include Unified Foodservice Purchasing Co-op (A&W, KFC, Long John Silver’s, Pizza Hut, and Taco Bell) and Restaurant Services, Inc. (Burger King). Besides their bottom-line impact, purchasing cooperatives also offer another, less tangible benefit: they help to build trust among franchisers and franchisees, particularly on pricing issues.

Cooperatives are leaders in other major industries, including media and news services (Associated Press), outdoor goods and services (Recreational Equipment Inc.), lodging (Best Western), carpeting (Carpet One), electrical distributors (IMARK), natural foods, and collegiate bookstores. . . .

[TAXATION OF COOPERATIVES]

As one form of business corporation, cooperatives calculate taxable income and use tax rates like other corporations, but with one principal difference. This difference reflects cooperatives' distinct way of distributing net margins to its patrons based on use, rather than to investors based on investment. . . .

The general principle of cooperative income taxation is that money flows through the cooperative and on to patrons, leaving no margins to be retained as profit by the cooperative. Thus margins are taxed only once. The tax is ultimately paid by the final recipient (the cooperative patron), although under some circumstances the cooperative pays tax on a temporary basis, then receives a deduction when the money is finally passed on to the
patron.

This single tax principle only applies if business income sources and distribution methods are "cooperative" in nature. Earnings from sources other than patronage and margins not distributed in the manner specified by the Code are generally not eligible for single tax treatment. The critical issue [is] in distinguishing patronage- and nonpatronage-sourced income . . . . General corporate income tax rules apply to earnings from nonpatronage sources and double taxation results.

When statutory conditions are met, cooperatives treat retained patronage refunds and per-unit retains as if the funds retained had been paid to the patron, deducted by the cooperative, taken into the patron's income as ordinary income, then invested in the cooperative. Conditions for this tax treatment include agreement by the patron to recognize the full patronage refund for tax purposes even though not received in cash or negotiable form.

Farmer cooperatives that meet several organizational and operational rules set out in Code section 521 are allowed to deduct two additional items: (1) dividends paid on capital stock and (2) distributions of nonpatronage earnings to patrons on the basis of their patronage.

Subchapter T of the Code, "Cooperatives and Their Patrons," contains most of provisions directly related to cooperative taxation and the taxation of patrons. Part I of subchapter T consists of three sections. Section 1381 describes cooperative organizations to which subchapter T applies. Subchapter T applies to all farmer cooperatives, including farmer cooperatives qualifying under section 521. A business need not be a farmer cooperative to qualify for subchapter T tax status. Any business "operating on a cooperative basis" uses subchapter T when computing its tax liability.

Farmer cooperatives file on form 990-C. Other cooperatives file form 1120. . . . Cooperatives must report such distributions to IRS (form 1096) and to the patron receiving the distribution (form 1099-PATR). Section 6044(c) provides an exemption from reporting for certain consumer cooperatives.

From here (the U.S. Department of Agriculture source is in the public domain).

READ MORE - Corporate Taxes Are The Exception

Square State Corporate Law

If I were advising a company about to go public on whether it should choose Colorado's corporate law, rather than say, Delaware's corporate law, would I do so?

Probably not. Why?

It isn't because Delaware corporate law is motivated by director primacy. My reasoning would be more mundane.

One of the biggest concerns for counsel seeking to incorporate outside Delaware or New York is that there simply isn't much modern corporate law precedent in any given non-Delaware, non-New York State jurisdiction on a great many issue of concern to publicly held corporation lawyers. Few states besides these states have any significant trial court reporting of corporate law rulings.

By my count, for example, which almost certainly double or triple counts a few cases, Colorado has fewer than 57 cases (state appellate and federal trial court and appellate) decided in 1980 or later (the last thirty-one years) interpreting its corporate code, some of which have been superceded by subsequent legislation (e.g. a line of cases concerning the duties of directors of insolvent corporations to creditors), and others of which deal with issues that only come up for "amateurs" and closely held corporations (e.g. the effect of failing to file a certificate of incorporation and the state's alter ego cases), rather than the kinds of issues (e.g. director obligations in regard to poison pills) that matter to large publicly held corporations with reasonably competent counsel. In state court, a significant share of those cases would also be federal court cases that are only persuasive authority (and a fair number of the Colorado precedents in the state reverse prior federal court holdings on corporate law issues in the state), and on any given issue, only a handful would be relevant.

For example, there are just three reported cases in the history of the state on indemnification of officers and directors, and just two on director conflicts of interest. Just one case in the history of the state addresses the business judgment rule or a director's duty of loyalty. There are two reported cases in the history of the state on derivative actions. The last time there was a reported decision on a proxy fight in Colorado was in 1956.

Delaware law and New York law, because each has quite different statutory language, often does not offer very persuasive precedent on Colorado corporate law issues.

Colorado's corporation code is well written and regularly updated to address the concerns raised by the bar. But, frequently, a lawyer forced to take a position on the meaning of the law when a corporate law issue presents itself must rely on the text of the statute, a decade old bar journal article, and equally thin precedents from other states with similar statutes, which makes for very thin (or very fat and not very definitive) legal briefs and memorandums of law. This is quite an uncomfortable position for a lawyer in a case where hundreds of millions of dollars may be at stake.

Again, to be clear, there is very little, if anything, wrong with the substance of Colorado's corporate law statutes. Indeed, on the merits, I probably would usually find Colorado's rule to be superior to that of Delaware when there is a clear difference, such as the arguably excessive ability of Delaware directors and officers to reduce their legal liabilities to shareholders relative to officers and directors in Colorado corporations. But, in a great many situations there is considerable ambiguity concerning what the statute requires when it comes to making a nitty-gritty line drawing legal judgment about what Colorado corporate law requires, since courts have particularly great latitude to decide cases of first impression.

The heavily litigated points of corporate law in Delaware are far less useful to closely held firms, and Colorado has more depth in its case law on issues of special relevance to closely held firms. Also, Colorado law, because it is not embellished with many layers of case law doctrine, provides few instances of laws that don't mean what they appear to mean for corporate officers and directors who, despite my best efforts, are determined to try to figure out the law for themselves, rather than consulting a lawyer.

Delaware's edge is also far narrower in the case of "uncorporations," such as limited liability companies, where no state has a long tradition of case law and individually drafted operating agreements matter more than express statutory rules.

As unfair as it is that the elected representatives of the state of Delaware should get to decide how corporate law is made for the vast majority of large publicly held corporations in the United States, for the foreseeable future, deficiencies in Delaware's corporate laws are more effectively addressed through federal law than through efforts to get corporations to incorporate in the states where they actually have their headquarters.

READ MORE - Square State Corporate Law

Health Insurers: Co-ops Too Awesome For Colorado

Usually, the argument for having the private for profit sector of the economy do something is that it lowers costs and is more efficient.

But, that isn't the argument that opponents of a plan to established a health care cooperative (i.e. a patient owned health insurance company) have made to Colorado's General Assembly in response to Senate Bill 168 which calls for establishing a commission to present the co-op proposal to voters in 2013.

According the today's Denver Daily News, "State Senator Shawn Mitchell, R-Broomfield, acknowledged that the plan itself does not create single-payer system in Colorado," but, he believes that it is likely that a co-op would expand and drive private carriers out of the market, becoming a single-payer or predominant payer in the state.

In other words, Mitchell believes that a co-op would provide a better deal to Colorado health care consumers that they would choose over the status quo of private health insurance companies.

Mark Reese, a spokesman for the Colorado Association of Health Plans, said as many of 20,000 people employed by the private health care insurance industry in Colorado would lose their jobs as a result of a universal cooperative.

Translation: Health insurance companies are so wildly inefficient that a health insurance cooperative could do the same job with 20,000 fewer people.

As Senator Mitchell notes, this would not be a single payer health care plan like they have in Canada:

Senate Bill 168 would create a board of health care and policy experts [funded with $1.2 million of private donations] to develop details for implementing a health care cooperative that would include all Coloradoans as members. . . .

Coloradoans would be allowed to kept their primary insurance provide and instead use the cooperative as a supplemental policy.

Coloradoans would also be allowed to choose medical provider that is not part of the system. In those cases, patients would be required to pay the gap between the cooperative's reimbursement and the provider's charges.

The status quo indicates that there is considerable truth to the argument of cooperative opponents that government can manage health insurance claims with fewer employees than health insurance companies do. The Medicaid program in Colorado, for example, processes all of its claims in the state for its 553,800 beneficiaries with fewer than 900 employees.

Co-operatives are alternatives to anti-trust regulation and government owned enterprises that rely on the say members have in how the co-operative is run to keep them working in the member's best interests.

If a health care co-operative will, as opponents claim, provide health care at a lower cost than health insurance companies do, by providing health care with 20,000 fewer health insurance company employees whose wasteful paperwork is driving up the cost of health care in Colorado, then I am all for it.

The last time I checked, the objective of Republicans and Democrats alike was to reduce health care costs and cut waste in the health insurance industry without making unnecessary cuts in the health care that was provided. Indeed, the Republican critics of health care reform in Congress specifically made a point of criticising health care reform's failure to include enough of a focus on cost savings.

One doesn't have to be a died in wool ideological supporter of co-operatives for co-operatives sake to say that co-operatives are a good option when consumers choose them the buy services also offered by investor owned corporations in circumstances where co-operatives provide lower prices through more efficient operations.

It isn't as if Republicans in Colorado as a whole have some deep ideological opposition to co-operatives as a form of business organization in any case. In rural Colorado, co-operatives are the primary way people get electricity, receive their telephone service, buy their farm supplies, store their grain, sell their crops, and buy their water. In Denver, Republicans make up a disproportionate share of people who send their children to pre-school through co-operatives, and many people in Colorado already get life insurance, disability insurance and casualty insurance from mutual insurance companies (which is just another name for a consumer's co-operative) like Northwestern Mutual or Amica. A citizen owned football team won the Superbowl this year. Almost every law firm, accounting firm and medical practice in the state is organized as an employee owned enterprise.

None of this changes how health care providers are organized. From their perspective, a health care co-operative is just one more health insurance company to deal with in the billing process - a big one, according to opponents, but not an organization that is actually providing medical services directly to patients.

READ MORE - Health Insurers: Co-ops Too Awesome For Colorado

Should Liberals Care About NFL Unions?

NFL owners are seriously considering a lockout to push NFL players, who are unionized, to agree to an eighteen game season and other pro-football player contract reforms. Atrios says (via Steam Powered Opinions):

[L]iberals should care and side with labor, even if some of the players do make a lot of money. This is about how the pie gets split, and that matters even if it is a really big pie.

Analysis

I can't say that I share that sentiment very emphatically. Honestly, I don't have strong feelings about union-management relations in pro-sports generally.

The fact that pro-sports, and most of the performing arts, are organized into unions at the industry level is notable. This shows the potential for union power in industries with employers that are either small, or ephemeral (e.g. a movie production company or Broadway show run), which are ill suited to an employer based organizing approach.

Labor actions in these high profile fields are among the only labor actions that receive public attention in a modern union-management relations climate in which work stoppages have never been more rare.

But, these labor actions have not cast those unions in a very favorable light. The most recent writer's strike in Hollywood appears to have led to a permanent shift in favor of reality TV formats that have undermined union members. Appearing to deprive average Americans who have no strong economic stake with the owners or the talent of entertainment isn't a good way to make them your friends. The general American public has also been habituated to a distaste for public conflict over compensation in tough, battling ultimatum driven negotiations, something that they rarely experience in their own lives.

Indeed, in sports even more than in the other performing arts fields, the public media coverage of the money issues seems to take away from the enjoyability of the game itself. It tarnishes the images of all involved and the institution itself.

This isn't to say that I have lots of warm and fuzzy feelings for pro-sports team owners and management either. But, players and owners alike have a strong shared economic interest in extracting as much money from fans as possible. Why shouldn't liberals care as much about the size of this particular pie as they do about how it is split?

To be perfectly honest, despite Atrios' appeal to our liberalism, since I am not a die hard sports fan who stays abreast of the business of sports as well as the conduct of sports, I have very little sense of what share of the pie players, referees, and owners and managers of our professional sports leagues receive now, let alone whether there is any sensible reason for this mix. I do have a fairly fine tuned understanding of why different players get paid different amounts relative to each other and relative to other people in the labor market, from general economics discussions, but I know more about the relative split of profits in small enterprise, in movie productions, in investment banks, in utilities, in government and in industrial companies, than I do about industry specific divisions of loot in professional sports. (In fairness, he cites a Daily Kos diary that makes the case that players do get the shaft relative to franchise owners.)

Any responsible person, before taking sides in a dispute where someone seeks to change the status quo, ought to understand the status quo better than I do, rather than simply jumping on a bandwagon without regard to the merits. Surely, there is some fundamental sense in which the status quo is more or less fair, and favors one side or the other. Is the player's share fat or lean? Are management's demands sensible or oppressive? I certainly don't know the answer to those questions personally and would hesitate to have an opinion on how their negotiations should come out until I knew. While a presumption of unequal bargaining power between labor and management is reasonable in some contexts, it isn't at all obvious that such a presumption is appropriate in the case of NFL football players.

And, suppose that the split of the pie between NFL players and owners in the current status quo is unfair. My instinct is to wonder how that came to be, given that the status quo itself was a product of union-management negotiation. Perhaps, something else in the system of union-management negotiations is broken. And, if it isn't broken, why should anyone involved care what I or anyone else in the blogosphere thinks? If union-management negotiations generally produce good results, why should we fear that it won't do so this time around?

Do Unions Benefit Athletes?

Any effect that these unions have had in reducing compensation inequality among union members is less than obvious from pro-sports and the performing arts which have increasingly gravitated towards a winner takes all model, that owners have appeared (for the selfish reason of wanting a larger share of the pie) to advocated more than the talent. Is the second string outfielder or linebacker, or the chorus member in a Broadway show, or the infrequently recurring soap opera actress really better off because of the union? Perhaps, but these gains are often invisible to the general public, and are hard to quantify even for expert economists.

It is also far from obvious that pro-athlete unions do an adequate job of helping people who mostly have very high flying but short careers convert their brief moments of bounty into long term financial well being. I've known financial planners who specialize in that, but the extent to which they are used and the extent to which they are successful in achieving those ends, is decidedly mixed. Lots of athletes get feted and then thrown out and find that they have squandered their brief moments of plenty. Perhaps it is presumptuous to think that this is a job for athlete's unions, but being a liberal, I do think that.

The case that unions provide a negotiating edge is also atypical in pro-sports, because many or most pro-sports union members, unlike most ordinary union members, have professional agents on retainer who are charged with negotiating their contract terms to their advantage. While a typical union provides its members with both savvy in negotiations and power, the pro-sports player's union is purely a means by which to maximize employee power.

Liberal Instincts On The Organization Of Sports

My "liberal" instincts are instead to question whether it really makes sense for pro-sports teams to be organized as "for profit" entities at all, particularly in light of the ample public subsidies in the form of stadium construction and less tangible assistance in the form of public goodwill and loyalty, that members of the public provide to these teams.

Watching George W. Bush and his cronies in a box at the Superbowl brings to mind the underlying story about all that is bad about corporate sports. It also brings alive a question. Why, if the publicly held corporation is the secret to all great economic blessings, are pro-sports teams organized as closely held for profit businesses, rather than publicly held ones? These are capital intensive enterprises, so why don't they raise funds for stadiums with stock offerings and bond issuances?

A lot of the attraction of professional supports comes from tribal rivalry rather than the absolute quality of what actually takes place on the field. The fact that our professional soccer players aren't nearly as elite as our professional baseball players and get paid far less has only a modest impact on our feelings about rooting for the home team. If there was a national salary cap on compensation for pro-athletes of $100,000 per player, per year, we would still love pro-sports just as much. Appropriating that civic pride for private gain feels a little dirty to me.

In my ideal world, pro-sports teams might be owned by non-profits, perhaps affiliated with local governments and perhaps not, or organized as player owned organizations, although I can see that the very unequal and different in kind contributions of talent to these organizations might make a player owned form of organization problematic, because groups of co-owners tend to do a poor job of negotiating compensation arrangements with any degree of complexity among themselves.

On the other hand, I can't say that the college sports model, in which the immense enterprise that is centered around college athletes at large universities deprives those athletes of any compensation beyond scholarships, popularity and prospects of a pro-sports career, in the name of amateurism, is any better. In that circumstances, recognition of their legitimate contributions to the enterprise, which involve a great amount of work and commitment and produce economic benefit, are treated as a form of corruption.

Indeed, I am ambivalent about the linkage between education and organized sports at all. There is much to be said for the European model of having sports clubs independent of particular schools or colleges at all levels of competition. There is no deep reason that we should expect aspiring professional football, hockey and basketball players to attend college, while allowing aspiring professional baseball players to chase their dreams in the minor leagues instead.

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The Drivers And Costs Of CEO Pay and Inequality

I've written before about the pay of superstars in sports and entertainment, and the portion of a New York Times article discussing that point covers little new ground. The shorter version is that their performances reach a very large number of people.

Entity Size And Profits Drive Corporate Pay

The article's analysis of high corporate pay, however, bears closer attention. It attributes rising pay for the executives in the "real economy" to the increasing scale of big business, and rising pay inn the finance sector to profits made possible deregulation.

In 1977, an elite chief executive working at one of America’s top 100 companies earned about 50 times the wage of its average worker. Three decades later, the nation’s best-paid C.E.O.’s made about 1,100 times the pay of a worker on the production line. . . . in the 1970s found that executives in the top 10 percent made about twice as much as those in the middle of the pack. By the early 2000s, the top suits made more than four times the pay of the executives in the middle. . . . Two economists at New York University, Xavier Gabaix and Augustin Landier, published a study in 2006 estimating that the sixfold rise in the pay of chief executives in the United States over the last quarter century or so was attributable entirely to the sixfold rise in the market size of large American companies. . . .

In 2007 . . . . financial companies accounted for a full third of the profits of the nation’s private sector. Wall Street bonuses hit a record $32.9 billion, or $177,000 a worker. . . . Financiers had a great time in the early decades of the 20th century: from 1909 to the mid-1930s, they typically made about 50 percent to 60 percent more than workers in other industries. But the stock market collapse of 1929 and the Great Depression changed all that. In 1934, corporate profits in the financial sector shrank to $236 million, one-eighth what they were five years earlier. Wages followed. From 1950 through about 1980, bankers and insurers made only 10 percent more than workers outside of finance, on average. . . .

By 2005, the share of workers in the finance industry with a college education exceeded that of other industries by nearly 20 percentage points. By 2006, pay in the financial sector was again 70 percent higher than wages elsewhere in the private sector. A third of the 2009 Princeton graduates who got jobs after graduation went into finance; 6.3 percent took jobs in government.

The authors attribute the gains in the tides of financial industry pay largely to government regulation, which tightened during the Great Depression and on through about 1959, and then was relaxed in the late 1980s and 1990s.

A critical point to keep in mind is that the increased pay have top executives in big business or finance has a great deal to do with ability to pay and very little to do with actual competence.

Big businesses and financial firms offer an amount based on the scale of their enterprises and the amount of profit their firm creates, in the hope of attracting the best talent. But, while there is considerable evidence to indicate that better pay does lure better rank and file professionals to an industry or enterprise, there is very little evidence to indicate that big businesses are able to accurately discern which applicants for exhorbitantly paid top jbs are actually the best one, and there is considerable evidence to indicate that big businesses do an absolutely mediocre job of removing top executives who have failed to live up to the expectations upon which they were hired from their posts.

The Diminishing Marginal Returns Of Winner Take All Compensation

Put another way, if big businesses had hired someone from the same pool as the person actually hired who was willing to work for half a much compensation, there is very little to indicate that the business would be run any less well. One can find very compentent managers willing to work for $1,000,000 a year, and the marginal benefit accrued by offering $10,000,000 a year instead is not at all obvious.

This concern is particular great in the case of successor CEOs. One can argue that founders of firms have earned their great wealth by creating the firms that generate it. But, this point is much harder to make when a successor is appointed to manage to wealth created by his or her predecessors.

The divide between the rich and the megarich is driven by the concentration of economic activity into a smaller number of firms that is largely a product of economy of scale incentives in the economy, not by the fact that there is an immense divide in talent between the rich and the megarich.

Indeed, the concentration of rewards at the very top can actually create counterproductive incentives:

If only a very lucky few can aspire to a big reward, most workers are likely to conclude that it is not worth the effort to try. The odds aren’t on their side. Inequality has been found to turn people off. A recent experiment conducted with workers at the University of California found that those who earned less than the typical wage for their pay unit and occupation became measurably less satisfied with their jobs, and more likely to look for another one if they found out the pay of their peers. Other experiments have found that winner-take-all games tend to elicit much less player effort — and more cheating — than those in which rewards are distributed more smoothly according to performance.

Counterproductive winner take all effects are the private sector equivalent of the Laffer Curve, the notion that at some very high marginal tax rate (far in excess of anything found in the U.S. or even European economies), increasing taxes reduces tax revenues because it creates an disincentive to work. There is a point at which increasing compensation to top performers actually decreases the productivity of the economic unit as a whole.

The Drivers and Economic Impacts Of Income Inequality

The article also notes the trend towards exceptionally high income inequality in the American economy, and its tenuous relationship to economic growth (emphasis added):

Since 1980, the country’s gross domestic product per person has increased about 69 percent, even as the share of income accruing to the richest 1 percent of the population jumped to 36 percent from 22 percent. But the economy grew even faster — 83 percent per capita — from 1951 to 1980, when inequality declined when measured as the share of national income going to the very top of the population.

One study concluded that each percentage-point increase in the share of national income channeled to the top 10 percent of Americans since 1960 led to an increase of 0.12 percentage points in the annual rate of economic growth — hardly an enormous boost. . . . Since 1980, the weekly wage of the average worker on the factory floor has increased little more than 3 percent, after inflation. . . . According to the Organization for Economic Cooperation and Development, the average earnings of the richest 10 percent of Americans are 16 times those for the 10 percent at the bottom of the pile. That compares with a multiple of 8 in Britain and 5 in Sweden. . . . There is a 42 percent chance that the son of an American man in the bottom fifth of the income distribution will be stuck in the same economic slot. The equivalent odds for a British man are 30 percent, and 25 percent for a Swede.

Keep in mind tha the 3% real increase in wages for factory workers since 1980 has not been 3% per year, but instead is 3% total. On an annualized basis, that is an increase of about 0.1% per year -- for example, a rate of about $40.00 per year for someone making $40,000 a year.

What the international comparisons citred by the New York Tiems do not reveal is the root causes of the differences in income inequality between the United States and continental Europe. It turns out that the bulk of the difference is due to government policy. The less well off are better in Europe because the net deal of taxes paid v. transfer payments received there is better than it is in the United States.

The pre-tax, pre-transfer payment earnings of the less well off are just as stagnant in Europe as they are in the United States, but Europeans have sweetened the pot for the average person to share the wealth their economies have grown, while the Americans have not.

This analysis tends to suggest that the poor in America have a comparatively wretched and insecure existence not because they are less able to contribute economically, but because our political system does not see everyone as being in the same boat to the same degree. It is plausible to hypothesize that this, in turn, has a lot to do with the fact that the less well off are far more likely to participate politically in Europe than in the United States. In Europe, the share of the voting aged population that votes is 50% to 100% greater than in the United States. Non-voters are ignored politically, and the correspondence between those who don't vote (the poor and uneducated, particularly minorities, and children) and those who receive meager governmental support by international standards, is probably not coincidental.

Notably, forcing the beneficiaries of economic growth to share their gains with the rest of the nation has not, as conservative economic intuition would suggest, had any significant effect on the rate of economic growth. In countries with mixed economies where one's earnings still significantly impact one's socio-economic well being, even significant taxation to fund transfer payments doesn't distort the economy very much, because insuring that that there are real economic incentives in earnings for economically productive conduct turns out to be much more important than the intensity of those economic incentives. The ability to capture much of your contribution to economic growth is very nearly as motivating as the ability to caputre almost all of your contribution to economic growth.

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