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

Middle Class Income Tax Rates At Roughly 40 Year Lows

Average and marginal income taxes for those making the median income and twice the median income are mostly at forty year lows.  Taxpayers making half the median income have never paid less in income taxes (the average income tax rate is a negative percentage of income), but have the highest marginal income tax rates of all taxpayers, due to the effects of various refundable tax credits, the standard deduction and personal exemptions.

The bottom line, here, and across the board in the area of federal taxation, is that in a time period where we have federal budget deficits, it has never made less sense to close those deficits entirely or mostly through spending cuts.  We have large budget deficits, at the federal level, and have almost overconstrained state budgets in Colorado that have forced painful cuts, mostly because we made deep tax cuts during an economic boom while fighting two regional wars, without paying for them.

From the perspective of overall economic growth and the employment situation, we should be spending more in the public sector, at a time when private sector demand is anemic and investment activity is tepid.  Instead, we are cutting back on public services at a time when our economy has massive amounts of slack resources and above average demand for public services.

Also, our current extremely generous tax code is full of special interest tax breaks that constitutes autopilot meddling with private economic decisions that picks winners and losers in the business world, rather than letting the marketplace carry out that function, continues to be a force driving increasing systemic risk in our economy, and dramatically increases the dead weight transaction costs associated with tax code compliance and tax planning that its one of the regulatory costs of government that truly does hit small businesses the hardest.

Accumulated tax code crud is inevitable.  A tax code will never be ideal once and for all.  Revenue needs change, new kinds of transactions are invented, politicians are compelled to respond to urgent cries from the public for tax tweaks great and small to be responsive.  But, like a garden, the tax code requires continuous weeding of provisions that damage the whole and planting of improved provisions if it is to satisfy the public need for revenue in a way that doesn't do unnecessary harm to the economy.  Congress has put off that unpleasant task for too long, and the result has been ugly.

But, the solution is not to shut down the IRS, to hire private collectors, to pass further special interest tax break, to pass a consumption tax, or to mimic sometimes lower foreign corporate tax rates without expanding the tax base as countries with lower corporate tax rate do.  Instead, it is to take on the unpleasant business of repealing a great many tax breaks, in a way that increases the amount of revenue produced by the income tax, makes the tax code more economically neutral, and reduces the complexity and tax planning opportunities that great dead weight drags on the economy.

READ MORE - Middle Class Income Tax Rates At Roughly 40 Year Lows

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

Back Door Cramdowns?

The general rule under the United States bankruptcy code is that when loans are secured by collateral in a reorganization (rather than a liquidation), that the loan is broken up into two parts for bankruptcy purposes - one equal to the value of the collateral which is entitled to receive value in the bankruptcy equal to at least the value of the collateral (often by being given a loan with a principal amount equal to the value of the collateral and otherwise the same interest rate, amortization period and other terms as the original loan), and with the othe part equal to the remainder of the loan that receives the pennies on the dollar or no payout that other general unsecured creditors (like ordinary corporate bond holders and credit card copmanies) receive. The reduction of the loan to the value of the collateral is called a cramdown. Mostly, cramdowns apply to business property bought with secured credit and vacation properties with mortgages.

Residential mortgages and most car loans aren't eligible for cramdown treatment in bankrupty. The debtor must either reaffirm the loan in full, even if the collateral is worth less than the loan, or surrender the property.

There is a gray area in the case of residential mortgages that is turning out to be quite relevant. Often, a house in bankruptcy in an areas where there has been a housing price bubble collapse will have two mortgages. The first mortgage will clearly not be eligible for a cramdown. But, what about the second mortgage? If the value of the house is less than the amount of the first mortgage, is the second mortgage really a mortgage at all? Or, is the second mortgage really just an unsecured debt like a credit card because its claim against the collateral is contingent and only a remote future possibility?

A recent newspaper article in the Mercury News reviews this legal battle. According to the article, "bankruptcy lawyers say the provision has been used effectively on hundreds, if not thousands, of cases in the Bay Area during the past two years." The California Mortgage Bankers Association is unhappy about this trend, but sees few options on the legislative front in a divided Congress. On the other hand, "there are no complaints from investors in first mortgages, like the pension and retirement funds represented by the Association of Mortgage Investors."

Income tax deductability and funding from mortgage backed securities made splitting low down payment mortgages into a a conventional first mortgage with an 80% loan to value ratio, and a second mortgage with a higher interest rate that covered the balance except for a small down payment, attractive compared to a single larger first mortgage with title insurance. Second mortgages used to extract cash from a house that had appreciated in value during the housing bubble were also popular.

The issue has a special tenor in California where residential mortgages are generally non-recourse. There, the only way that a lender can collect is out of the collateral, so a bankruptcy proceeding that wipes out a second mortgage lien wipes out any remedy for the lender.

There are two narratives that explain the trend to deny the cramdown to residential mortgages.

One is that it protects lenders from being penalized by artificially low appraisals in bankruptcy court. If the property is really worth less than the loan, a rational bankruptcy debtor would give up the property and escape the mortgage debt in bankruptcy, so a cramdown should only take place if the appraisal undervalues the property providing an undeserved benefit to the debtor. Similarly, an appraisal based only on current comparables fails to capture appreciation in real estate that may be available in a short time during a temporary real estate price slump. These concerns don't seem to have been well supported, however, by the experience in Chapter 12 farm bankuptcies, where cramdowns are allowed.

The other narrative is that home owners aren't rational. They attach sentimental, and dignity related and moving cost related value to their home that no lender could realize if the home were foreclosured upon or surrendered. In this narrative, denying residential home owners a right to cramdown mortgage loans is a way of giving residential mortgage owners more than their fair share in a bankruptcy every time a debtor keeps a home that has a fair market value of less than the face value of the loan.

It is unclear how common this situation is in Denver. Internet real estate appraisal service Zillow.com says 41% of meto Denver homeowners owe more on their mortgages than their homes are worth, and many of those homes would have second mortgages. But, Standard & Poor's/Case-Shiller, which experts believe is more accurate (Forbes actually dropped them as a source after obvious gross errors in their statistics were pointed out), concludes that housing values have declined far less than Zillow concludes, and hence far fewer homeowners are upside down. Case-Shiller consistently ranks Denver as one of the twenty major housing markets least impaired by the housing bust, while Zillow counts Denver as the second hardest hit market in the nation. Like other observers, I'm strongly inclined to give Case-Shiller more credit than Zillow for accuracy on this point. Too much other data corroborates the conclusion that Denver's real estate market has declined less than those of many other markets in places like California, Arizona, Nevada and Florida.

READ MORE - Back Door Cramdowns?

Obama Concedes DOMA is Unconstitutional

Learning a lesson from the decision of California's leaders in the Prop 8 litigation, where the state refused to appeal a trial court finding that Prop 8 was unconstitutional (the standing of the ballot measure proponents to appeal in that case has been certified to the California Supreme Court), President Obama has directed the Department of Justice to stop defending the constitutionality of Section 3 of the Defense of Marriage Act. The Justice Department has said:

The Attorney General made the following statement today about the Department’s course of action in two lawsuits, Pedersen v. OPM and Windsor v. United States, challenging Section 3 of the Defense of Marriage Act (DOMA), which defines marriage for federal purposes as only between a man and a woman: . . . The President has also concluded that Section 3 of DOMA, as applied to legally married same-sex couples, fails to meet that standard and is therefore unconstitutional. . . . [T]he Department will not defend the constitutionality of Section 3 of DOMA as applied to same-sex married couples in the two cases filed in the Second Circuit. We will, however, remain parties to the cases and continue to represent the interests of the United States throughout the litigation. I have informed Members of Congress of this decision, so Members who wish to defend the statute may pursue that option. The Department will also work closely with the courts to ensure that Congress has a full and fair opportunity to participate in pending litigation.

Furthermore, pursuant to the President ’ s instructions, and upon further notification to Congress, I will instruct Department attorneys to advise courts in other pending DOMA litigation of the President's and my conclusions that a heightened standard should apply, that Section 3 is unconstitutional under that standard and that the Department will cease defense of Section 3. . . .

Section 3 of DOMA will continue to remain in effect unless Congress repeals it or there is a final judicial finding that strikes it down, and the President has informed me that the Executive Branch will continue to enforce the law. But while both the wisdom and the legality of Section 3 of DOMA will continue to be the subject of both extensive litigation and public debate, this Administration will no longer assert its constitutionality in court.

Colorado's Attorney General, John Suthers, has filed an amicus brief arguing that the Courts should uphold the constitutionality of Section 3 of the Defense of Marriage Act, despite the fact that it does not directly impact state law, over the outraged protests of supporters of gay rights in Colorado.

Section 3 of the Defense of Marriage Act states that the federal government, when applying federal law, shall disregard legal state law marriages that are not between one man and one woman.

The key parts of the Defense of Marriage Act state that:

Section 2. Powers reserved to the states:

No State, territory, or possession of the United States, or Indian tribe, shall be required to give effect to any public act, record, or judicial proceeding of any other State, territory, possession, or tribe respecting a relationship between persons of the same sex that is treated as a marriage under the laws of such other State, territory, possession, or tribe, or a right or claim arising from such relationship.

Section 3. Definition of "marriage" and "spouse":

In determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States, the word "marriage" means only a legal union between one man and one woman as husband and wife, and the word "spouse" refers only to a person of the opposite sex who is a husband or a wife.

The decision does not by itself affect Section 2 of the Defense of Marriage Act which provides that the full faith and credit clause of the United States Constitution does not extend to same sex marriages. Thus, state, local, territorial and Indian tribe governments are not federally required to honor same sex marriages that are valid in other states.

Will President Obama's Position Be Sustained In the Courts?

President Obama's decision is likely to stick. Generally, the only parties with standing to participate in a case where a same sex couple alleges that their rights have been violated by Section 3 of DOMA are the federal government and the couple(s) bringing the lawsuit. The U.S. Supreme Court, particularly in recent years, has construed taxpayer standing (alleging the federal funds are used for an unconstitutional purpose) and citizen standing (alleging that the federal government is acting unconstitutionally) very narrowly.

I'll have to look later at the standing of members of Congress to speak for the federal government in litigation or intervene in lawsuits attacking the constitutionality of a statute. The general rule is that the Justice Department is the sole representative of the U.S. position. But, federal courts have the authority, although not necessarily the obligation, to appoint a lawyer to argue for a position like that constitutionality of a law or the rights of pro se parties, that is not represented by a party in court.

To speak for Congress, per se, or even one house of Congress, would ordinarily require the passage of a resolution by Congress or at least a house of Congress. But, members of Congress who sponsored or voted for legislation might be viewed by a court as suitable intervenors to argue to a court for a position that no party to the suit is willing to advance.

An IRS ruling last year holding that domestic partners in California were entiteld to split income for federal income tax purposes due to community property principles foreshadowed the changing position of the Obama administration on this issue.

Consequences

From a practical perspective, some of the main consequences of the decision are that gay married couples can file tax returns with married filing jointly status (and receive all of the benefits of married couples for estate taxation purposes), that same sex married couples qualify for federal immigration law treatment of spouses, and that same sex married couples can receive Social Security survivors benefits and spousal Veteran's benefits. The Veteran's benefits issue looms large now that Congress has repealed the "Don't Ask, Don't Tell" law.

Also, while not quite spelled out by this ruling, the implication seems to be that a same sex couple that is legally married in any state will thereafter be treated as married by the federal government, even if the state in which they live does not recognize same sex marriage. Since some states do recognize same sex marriage (and allow non-residents to be married in their state), that means that same sex couples that go to those states to be married and then return to their home states can receive all of the federal government benefits of marriage.

In addition to undermining the efforts of state governments to deny federal benefits of marriage to same sex couples in their own states, the determination also increases the stakes in the civil union v. gay marriage debate in the states. Until now, this has been a strictly symbolic debate. A civil union bill (SB 11-172) that creates as the legal rights and responsibilities of marriage under state law, but doesn't call it marriage (such as one pending in the Colorado General Assembly right now) would not constitute marriage under federal law, while one that calls the relationship marriage would have that effect.

Thus, states are left with multiple options including: (1) disallow both civil unions and same sex marriages, but acknowledge that couples with legal sex sex marriages from other states may receive federal treatment as married, (2) allow civil unions but not same sex marriage, which gives copules state law marriage rights but denies couples federal treatment as married until they get legally married in another state, or (3) allow same sex marriage.

Also, while Section 2 of DOMA does not require states to recognize same sex marriages from other states, it also does not prohibit them from doing so out of comity. In many states, the issue of when comity should recognize other state's legal acts when the full faith and credit clause of the United States Constitution does not require it has been left to the courts rather than being made a subject of legislation. Thus, judges could choose, influenced but not bound by the Section 3 of DOMA interpretation, to honor out of state same sex marriage even though the constitution and federal law do not require them to do so.

Civil unions have been a sensible legislative objective for same sex couples in many states, like Colorado, where the state constitution has been amended to prohibit same sex marriage, but not more broadly to prohibit civil unions or domestic partnerships of same sex couples as well. But, there will be increasing pressure to actually call this marriage legislatively, and as courts evaluate the issue.

READ MORE - Obama Concedes DOMA is Unconstitutional

Simplifying Taxes For Individuals

The President is considering a call for an income tax overhaul next year. One of the objectives is tax simplification. This is possible, without significantly changing overall tax revenues, without greatly rearranging the distribution of taxes due for low income taxpayers, and with a far more rational marginal tax rate structure for working class taxpayers than the current regime.

In this post, I'll lay out thirty key elements of a core tax simplification package, without much background or detailed proofs that these results are achieved.

End all net federal income and FICA taxes on the first $20,000 of income per married couple and $10,000 of income per single person.

1. Increase the standard deduction to $20,000 to married couples filing jointly, and $10,000 for married couples filing separately and single taxpayers.

2. End the special standard deductions for the elderly and the blind. End the phase out of itemized deductions.

3. Create a income tax credit for individuals equal to the amount of FICA taxes owed on the first $20,000 of wages (and to the extent not fully used for wages, of self-employment taxes owed on self-employment income) earned by a married couple filing jointly, and the first $10,000 of wages (and to the extent not fully used of self-employment income) of married copules filing separately and single taxpayers. Allow the FICA tax credit as a credit against both ordinary income tax and alternative minimum tax liabilities. Do not phase this out

Pay stubs and W-2s would reflect the FICA tax paid and the FICA tax income tax credit applied against it, and withholding tables would be adjusted to reflect cases where a married couple filing jointly has only one employed individual or a worker has multiple jobs.

4. The only penalty for failure to report income that would not have been subject to income or FICA taxes or self-employment taxes after the standard deduction and this tax credit would be a failure to receive credit for those earnings in the calculation of Social Security benefits.

5. Employers would get an income tax credit equal to the amount of employer FICA taxes paid on the first $10,000 of wages per employee per year, with withholding tax tables adjusted accordingly. All this credit against both ordinary income tax and alternative minimum tax liabilities. Do not phase this out.

Replace the benefits related to having children in head of household filing status, the per child tax credit, personal exemptions and the earned income tax credit, with a single, simpler per child tax credit.

6. Establish a fully refundable $3,000 per child tax credit.

In the case of married couples filing separately, or children with two parents who are not married to each other, each parent would get a $1,500 per child tax credit unless otherwise agreed in writing or otherwise allocated in a court order. Allow this per child tax credit against both ordinary income tax and alternative minimum tax liabilities. Do not phase this out. Do not require proof of financial support or parenting activities; any parent with parental rights is eligible for it until a written agreement or a state court order allocates it otherwise.

7. End the head of household filing status, personal exemptions, the phase out of personal exemptions, the existing per child tax credit, and the existing earned income tax credit.

Adjust marginal tax rates to produce similar revenues from individuals with similar income to the current regime

8. Replace the 10% and 15% marginal income tax rates with a 20% income tax rate up to the point where the 25% marginal income tax rate starts.

Simplify selected itemized deductions

9. End the percentage of AGI cap on medical expenses including health insurance expenses, and allow the medical expense deduction against self-employment taxes as well as income taxes. This result can already be achieved under current law in a variety of ways with various forms of tax planning.

10. End the deduction for state sales taxes.

11. End the second home mortgage interest deduction.

12. Limit the mortgage interest deduction loan amount for new loans to the greater of the existiing amount of mortgage interest deduction loan eligible debt, or the purchase price of the residence plus the amount of any capital improvements financed with a construction loan, rather than the fair market value of the residence. This would make it impossible to take out home equity loans borrow against paper increases in housing values, an incentive that contributed significantly to the financial crisis.

13. Make the private mortgage insurance deduction permanent.

Simplify the taxation of Social Security benefits

14. Include half of Social Security benefits received in income in lieu of existing formulas. This reflects the fact that half of Social Security taxes were collected before tax and half were collected after tax, paralleling the tax treatment of other retirement benefits. Existing means tested social security benefit inclusion would be repealed.

Simplify retirement contribution taxation

15. Limit the income that can be considered for all employer based, qualified defined contribution and defined benefit retirement plans (such as 401(k) plans, defined benefit pension plans, cash balance plans, profit sharing plans, SEP and Simple IRAs) to the Social Security wage base and impose a uniform cap on contributions for all plans of an employer to 15% of FICA wages paid.

16. Cap IRA, Roth IRA and Keogh plan contributions at 15% of wages earned from employers without a retirement plan of any kind plus 15% of self-employment income.

17. End the retirement savings contributions credit.

Simplify selected business expense deductions.

18. Disallow a deduction for any business meals for employers or clients, and for business entertainment for employers or clients. But, do not include these meals and entertainment in the income of the person receiving them.

Food and entertainment are personal benefits to whoever receive them that in a transaction cost free world would be taxed as compensation income to the person who benefits. Disallowing a deduction for these expenses instead imposes a tax in lieu of a tax on the person who benefits on the person who pays for them, a rough justice solution that results in similar levels of taxation. This expense item invariably eats up a disproportionate share of IRS audit resources and compliance costs for taxpayers.

19. Allow self-employed individuals who have no other office, own or rent a home, and have a permanent designated office in their home, a standard deduction of $5,000 or the amount of their business profit, for the year, whichever is less, for a home office. Someone who takes a home office deduction may not deduct expenses for rent, mortgage interest, utilities, or a landline phone that is not dedicated exclusive to the business. Home office expenses can be itemized in lieu of the home office deduction under existing rules.

20. Make simplified business use of a cell phone tax deduction rules permanent.

21. Replace the child and dependent care expense credit with an above the line deduction covering a comparable amount of such expenses.

22. Consolidate the educator expense deduction, the deduction for business expenses of reservists, performing artis and fee based government officials, the moving expense deduction, the student loan interest deduction, and the itemized deduction for employee business expenses into a single above the line deduction for employee business expenses in excess of $200 per year on a return for a single person or married filing separately return, and in excess of $400 per year on a return for a married couple filing jointly. Allow expenses required to maintain a license as a lawyer, doctor, engineer or other profession on this line for employed individuals and as a business expense for self-employed individuals.

23. End the deduction for tuition and fees, instead using education tax credits as the way to provide tax incentives for tuition and fee payments.

24. End the domestic production activities deduction (Section 199).

Equity Based Compensation

25. Compensation in the form of an ownership interests in a company in exchange for services, including carried interests in private equity funds, should have a zero basis and be taxed only when sold, without regard to its marketability, and then treated as ordinary earned income subject to self-employment taxation when sold. In publicly held companies, individuals owning stock received in exchange for services may elect to make a deemed sale of the stock and repurchase of the shares for the cash earned at any time.

26. Compensation in the form of stock options in a company in exchange for services should be not be taxed when the option is exercised. At that point the stock should be treated as compensation in the form of an ownership interest in the company in exchange for services, except that it would have a basis equal to the exercise price of the option, rather than zero. Incentive stock option rules under current law and the AMT would be repealed for options issued after the effective date.

27. End the penalty tax on straight compensation in excess of $1,000,000 per year.

Adjust The Self-Employment Income Tax Base

28. Include tips earned in self-employment income rather than in wage and salary income. Thus, employers would not be required to withhold taxes for, or account for tips, other than to issue 1099s to employees for tips paid to the employer and then paid in turn to employees, rather than paid directly to employees.

29. Include K-1 income from all S corporations and partnerships in which the taxpayer is active in the business as self-employment income (except to the extent that it is unearned income).

30. Include royalties from creative works that one has authored in self-employment income.

READ MORE - Simplifying Taxes For Individuals