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 Dislikes Class Actions

Today, a conservative majority of the U.S. Supreme Court in a 5-4 decision, held that a sex discrimination case against Wal-Mart on behalf of its 1.5 million female employees could not be certified as a class action lawsuit. (There was wide agreement that the backpay due in the case could not be handled on a class basis, but there was deep dispute over whether the existence of gender discrimination at the company could be litigated in that manner.)

This is the latest of a string of cases that have disfavored class actions, such another this term that held that the right to conduct a class action arbitration could not be implied from a simple arbitration clause and that the fact that an arbitration clause expressly prohibits class actions could never be sufficient to render it unconscionable under a provision of the federal arbitration act that allows arbitration clauses to be invalidated if they would be unconscionable under state law.   The rulings have largely been statutory or based on court rules, thus they are more easily overriden than rulings based on constitutional grounds, but the rulings are colored by a deep distrust of the class action generally.

Concerns about class actions have also been a central to the tort reform movement, and have been an area where the movement has achieved more than one significant victory, by imposing major procedural limitations on securities law class actions, and by giving the federal courts jurisdiction over many class actions arising under state law that would not qualify for diversity jurisdiction.  Today's ruling, interpreting the class action rule in the federal rules of civil procedure, thus, has wider implications for class actions generally, than it would have a couple of decades ago, because more kinds of class action lawsuits are confined to the federal courts.

To some extent, the distate of big businesses for class actions, and plaintiff friendly group's support for them is simply a matter of mathematics.  In a situation where there are many people with small claims against a single business or small group of businesses, large numbers of people with claims will never choose to bring valid lawsuits because the litigation cost economics don't make sense, and except in the very clearest cases, the verdicts will be a mixed bag.  In contrast, a win in a class action will afford a remedy to everyone with a claim (or a proxy for them) and a win on behalf of all claimants is possible even when a win on the liability issue isn't a sure thing in any given isolated case.

There is also considerable controversy over the fact that "coupon settlements" and contributions to non-profit caues often replace money awards as typical class action remedies, that class actions are expensive to litigate and rarely result in a resolution on the merits by a judge, that there are often multiple competing class actions that must be consolidated arising from single incidents, that forum shopping can be especially problematic in these cases, and that the cases can seem to be attorney driven rather than focused on providing a remedy for a client.  The high cost and long litigation times involve in class action litigation don't speak well for a process which was invented to reduce litigation costs and handle numerous related small claims more efficiently than traditional litigation efforts.

On the other hand, class actions can put pressure on big businesses to comply with the law even when the state regulators of an industry are asleep at the switch, underfunded, run by a political appointee hostile to the agency's purpose, or are the victim of capture by the regulated industry.  Class actions can close the gap between the laws on the books regulating an industry or practice,  and the law as actually enforced.  It can function as a remedy to corrupt administration of regulatory laws.  Class actions are also an arguable preferrable way to regulate industries through decisions by private individuals rather than actions by state officials whom many people who are inclined towards libertarian political ideologies may distrust.

In employment cases, the key attraction of a class action is the question of proof.  It may be much easier to establish discrimination on a statistical basis than it is to prove that it was present in an individual case, and it may be easier to fashion an affirmative action remedy in response to statistically proven discrimination than it is to wade through the details of a money damage remedy on a case by case basis.

But, class action cases can appear to grant legislative or regulatory type authority to courts whose procedures are primarily geared towards resolving disputes that involve only narrow disputes between small numbers of people.  This tendency is particularly apparent in false advertising claims where very large numbers of people are exposed to advertising claims and considerably numbers of people may buy products that are falsely advertised, but the individualized consumer harm may be modest.  Negotiations between alleged wrongdoers and alleged victim's representatives may also lead to court sanctioned remedies, such as certain forms of affirmative action, that could never be approved as legislation in the absence of a violation of the law that is never provided on the merits in court.

The trend seems contrary to the trends in our economy, in which big corporations whose mistakes routinely impact large numbers of people in incidents with a common source, rather than isolated incidents of wrongdoing, are increasingly the norm.  If a big money center bank calculated interest rates on loans, or forecloses on houses improperly, it will usually be because some system has gone wrong or some computer program had an incorrect rule, with the error affecting hundreds of thousands of people nationwide, rather than because there was some isolated defect in one customer's particular case.  Serious misrepresentations to consumers in commerce not infrequently involve massive advertising campaigns rather than an isolated vendor and purchasers in an open air marketplace.  Serious discrimination in employment practices frequently flows from bad leadership at the top of an organization that guides subordinate managers, rather than individualized misconduct by low level managers.  In our modern era of quality control systems in manufacturing, systemic defeats in mass manufactured products are more likely to cause harm than isolated duds that aren't successfully removed from the assembly line: most defective products are the result of a design defect, either in the product itself or the manufacturing process.  An inability to remedy systemic wrongdoing by a big business in a collective way is out of step with an economic reality in which a large share of all wrongdoing has a systemic source.  In the long run, it may be more important to the functioning of our economic to solve systemic problems than to remedy the one off screw ups that can never be completely eliminated.

For what it is worth, big government agencies, like the I.R.S., have many of the same weaknesses in offering remedies to systemic errors that put individuals in low stakes cases in bind, that big businesses do.

Some problems in the way that big businesses and big government operate, may be flaws in how they do justice between third parties who deal with them, rather than actually benefitting these entities themselves.  For example, most securities fraud involves cases where a misrepresentation by a business causes a stock price to fail to reflect the truth for some period of time, which benefits some secondary market stockholders to the deteriment of other secondary market stockholders, while having little or no direct economic impact on the company itself and where only a tiny part of the benefit or harm accrues to company insiders.  Often the beneficiaries and victims of the misrepresentation have no knowledge that they are acting in the basis of a misrepresentation until after the harm has been done. 

Yet, if misrepresentations with immense economic consequences for stock traders routinely lead to no repurcussions for the parties who make them, the soundness of our financial system is seriously undermined.  Some of the parties most responsible in fact for the financial crisis, the major credit rating companies, had very little other than their pitiful compared to the amount at stake in the economy fees, in their decisions, and will bear no consequences for their mistakes, and there is a movement in the securities law world to treat accountants the same way.  Yet, if the people whose observations drive the market have little stake in being accurate, the financial markets are certain to repeat its world economy shaking mistakes.  Millions of people are out of work and have been for many, many months, in substantial part because the tiny number of people on Wall Street who determined how creditworthy bond issuers were had an insufficiently compelling incentive to get their decisions right.

Part of the barrier to the problem is that power dynamics and self-interest driven policy stances are often so transparent in the tort reform area and in the area of class action litigation in particular, that it is hard to separate and address sincere and legitimate concerns from merely self-serving ones in the policy arena.  Also complicating the effort to find a fair way to deal with the cases that drive class action litigation is that extremely loose class action standards and substantive law claims that can be brought as class actions in a handful of states like California create extremes of the process that suggest solutions that aren't necessarily appropriate for the more strictly regulated federal courts or courts in states like Colorado where class action litigation isn't nearly so common.

READ MORE - SCOTUS Dislikes Class Actions

State Securities Law Class Actions In Colorado

Colorado had somewhere from 12 to 16 state court securities law class action lawsuits in the fifteen period from 1996 to 2010, six in the first five years, zero to four in the next five years, and six in the last five years. State securities law class action suits most often arise in states with many publicly held corporations headquartered there (Delaware, California, New York, and Texas) and most frequently involve merger and acquisition deal disputes. The highest number of suits was in 2009, with four, but other years had just zero or one or two filings.

READ MORE - State Securities Law Class Actions In Colorado

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

Extortion and Insider Trading

There are at least two quite different crimes both involving securing personal gain from other people's secrets. One is a subtype of extortion, where one makes money by promising not to reveal someone else's secret. The other is insider trading, where one makes money by acting on someone else's secret before it is revealed.

Secrets that are the subject of extortion threats are frequently not a crime or even a civil wrong giving rise to liability to publicly disclose. And, revealing a secret from an insider that materially affects the value of its stock to the general public before trading on it is likewise often neither a crime nor a civil wrong. Indeed, in both cases, revealing the secret is often considered a public service and is constitutionally protected. If the person who receives the secret does not act improperly in obtaining it, that person is generally free to disclose it, and even when a secret is obtained illegally, the punishment for the crime is often unrelated to the disclosure or non-disclosure of the secret and is frequently a misdemeanor.

It also isn't necessarily a crime or even civil wrong to profit from revealing someone else's secrets. While it would be a crime to extort cash not to publish information that someone had an affair, making money by selling that story to a gossip magazine or working as a private investigator using only legal means is perfectly legitimate. While trading securities on insider information is illegal, revealing negative inside information about a company in order to get a superior fired so that you can have a shot at that job when the vacancy arises. So it revealing negative insider information about a company so that stock in a competitor of a company becomes more valuable, so long as you already owned the competitor's stock it when you learned the inside information.

Nor is it a profit to keep other people's secrets, even for profit. Lawyers, doctors, mental health professionals, priests, accountants and many government employees are legally required to keep other people's secrets and are paid to do so. However, in those cases, the secrecy is promised in exchange for trust from someone who needs to know the information for reasons that often benefit the person who is the source of the secret, and the profit generally is from the secret's source or from someone who is financially indifferent to whether or not the secret is revealed.

In contrast, extortion and insider trading involve either harm or threatened harm to the source of the secret from others. In the case of both extortion and insider trading, not revealing the secret may harm the public, either because they are denied important negative reputational information about someone, or because they are inaccurately valuing a security and being exploited by someone else as a result of that inaccurate valuation.

READ MORE - Extortion and Insider Trading

Colorado Securities Act Trumps Forum Selection Clause in Contract

As a general rule, parties to a contract can decide where disputes arising under the contract or between the parties in relation to the transaction are litigated and according to which state's law. When this is part of an arbitration clause, state law determinations that a choice of forum are frequently pre-empted by the Federal Arbitration Act. But, what if the contract provides that suits may be brought in ordinary courts, but only in a particular state?

If that contract is a contract related to a sale of securities that are regulated by the Colorado Securities Act because sales are made by a business with Colorado offices from which it conducts business, the Colorado Court of Appeals has held that the contract's forum selection clause is void as violation of a public policy articulated in that statute in an anti-waiver provision.

The Colorado Court of Appeals followed precedents interpreting similar issues under Colorado's Wage Claims Act and invalidating an arbitration requirement in a case covered by Colorado's Wrongful Withholding of Security Deposits Act. California and Illinois have similarly used anti-waiver provisions to invalidate forum selection clauses.

The Colorado Court of Appeals rejected analogies to federal securities contracts in international situations where state securities law claims are also present, a situation where many federal courts have upheld choice of forum clauses. It also rejected analogies to arbitration cases, where a federal statute applies, and to change of venue motions in the federal courts which do not have an analogous provision for transferring a case to a different state in Colorado's state courts.

In the case decided, in which the clause also selected Texas law as applicable, the distinction was crucial, because the general partnership interests that were marketed are securities under Colorado law, but not under the state securities laws of Texas, and because the Texas securities law, on its face, does not apply to transactions conducted outside the state of Texas.

Notably, this case was not brought as a class action.

READ MORE - Colorado Securities Act Trumps Forum Selection Clause in Contract

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

Financial Risk and Insecurity

A few stray thoughts on risk.

1. One of the core organizing principles of bankruptcy law, securities law, the policy analysis of appropriate debt-equity levels in corporations, the regulation of gambling, Social Security policy, mandatory insurance regimes and more is the notion that generally speaking, people should only be putting at risk money that they can afford to lose.

For example, SEC private offering rules limit allow only "accredited investors" to invest significant sums of money in investments that are not subject to the disclosure regimes that applies to publicly held companies. Generally, qualification for this class of investments is some combination of wealth and sophitication, and criticism of the rules often argue that they are insufficient because they don't adequately protect the unsophisticated wealthy. But, part of the reason for a purely wealth based restriction on investments that pose potentially higher risks than the ordinary investment is the notion that the wealthy can afford to lose the money and go on in life, while widows, orphans and middle class families cannot.

2. One of the common ways to define the line between the rich and the merely upper middle class is that the rich don't have to work to meet their needs, and instead, can rely on their wealth to support themselves.

One can imagine a similar tack in defining other social classes. The poor are those who cannot support themselves from either their property or their labor. The working and middle and upper middle classes, together, can support themselves through their labor but need to work to support themselves, with the differences between those classes being mostly the level of comfort that they can afford themselves and the kind of work thath they do.

But, another way of thinking about social class in the middle range is in terms of security. How secure is one's job? Do you have adequate life insurance if you died? Do you have adequate disability insurance if you were disabled on a temporary or permanent basis? Do you have health insurance to allow you to receive medical treatment if you are sick or injured? Do you have adequate insurance to deal with a serious casualty to a car or a home or a tort lawsuit against you? Do you have adequate insurance to avoid ruin if you were sued for professional malpractice? Do you have sufficient savings or access to credit to defend yourself or a family member adequately in the event of a criminal prosecution? Could you take advantage of an opportunity to send a child to a good quality, expensive private school or college? How long could you afford to be unemployed before your life would fall apart? Could you economically weather a drug addition for you or your family and pay for treatment?

One of the reasons that the financial crisis crept up on us is that while a lot of people were able to maintain their lifestyles on a day to day basis, that the insecurity and fragility of their lifes increased.

There are a lot of people who are on the brink of disaster. A money without income would cause them to default on their credit cards, their lack of health insurance or inadequate health insurance means that they could afford to pay for the medical bills in a major illness or injury, they have no savings to prevent even a small financial misstep in revenue or expenses from leading to the loss of a home to foreclosure, eviction from a rental home, or repossession of a car.

A large share of these individuals get lucky and manage. They do get in enough money to pay the bills by happenstance and good luck and clever financial juggling. They don't get sick when they don't have health insurance. The avoid criminal prosecutions. They find a job swiftly after losing their old one before it all falls apart.

One can have a modest income and not be insecure. A lot of low ranking civil servants (e.g. postal workers, school janitors, parking enforcement agents, pre-school teachers, and library assistants), enlisted soldiers, military veterans, union employees (e.g. many grocery workers), clergy and simply thrifty prudent people who have never had very high incomes fit in this category, for example. This class of the low income but not insecure also includes a lot of bohemian trust funders often toiling away in "glamorous" but low paying positions - as ballet dancers, artists, poets, performance artists, non-profit professionals, eternal graduate students and post-docs, and lower tier politicians.

There are also reasonably high income earners who are fairly insecure. Many athletes and entertainers can be expected to have brief careers that produce high but intermittent incomes. Properous prostitutes and drug dealers are in much the same situation. Some farmers and fishers and foresters and miners make good incomes when commodity prices are high and yields are good, but have the thin safety net of the self-employed and if they have significant leverage may risk losing it all in less good times. Personal injury lawyers can make a lot of money in one case and then have long dry spells. Also prone to bursts of wealth between slow periods are commission salespeople and employees of high end establishments who are compensated mostly with tips. There is a significant shift from having enterprises meet their needs from employees to having them meet their needs from a disorganized safety-net free class of one job at a time independent contractors that has increasingly moved up their income ladder.

A step down from those on the brink of disaster is the growing class of people who aren't entirely destitute but also can no longer afford to "play by the rules." They are in default on one or more debts. They didn't pay their car registration or the taxes they owed. Their mortgage is upside down in a recourse mortgage state and they have no realistic hope of selling their home in anything other than a short sale for the foreseeable future. They are missing tuition payments at private schools or colleges. The numbers over at Calculated Risk every month suggest that the percentage of people in this situation is soaring. Rather than being chronically poor, they are the formerly middle class and working class but are in the midst of the long fall without a safety net that American society makes possible

There has always been a class of people who are prone to intermittent unemployment, but this class of people has grown, and the class of people who are intermittently underemployed has has grown invisibly but dramatically: skilled tradesmen who become day laborers in bad times; teachers who become substitute teachers and retail workers in bad times; farmers who do handyman work when crop revenues are modest and more skilled construction work isn't available in the off season; construction business owners and engineers who do ordinary construction work rather than managing others when the industry is weak; CPAs who do simple book keeping when more sophisticated employment is not available.

Public policy has a few nods to these classes of people - the right to cure a mortgage or rent payment that is in default, the Chapter 13 bankruptcy, COBRA, the right to emergency stabilizing treatment at emergency rooms, credit counseling agencies, offers in compromise and installment payment tax plans, personal recognizance bonds and probation sentences for criminal defendants, and unemployment insurance, for example, but the effort isn't very comprehensive or thoughtful.

READ MORE - Financial Risk and Insecurity

Feds Take Aim At Investment Banks

The National Credit Union Administration is a federal regulatory institution for credit unions roughly analogous to the FDIC for commercial banks. The credit union industry is structured in two main tiers. As the Wall Street Journal explains today:

The wholesale credit unions, also known as corporate credit unions, are at the heart of the nation's credit-union system. They not only invest customer deposits but also provide services such as check clearing for nearly 8,000 "retail" credit unions—member-owned cooperatives that act somewhat like banks for firefighters, teachers and other workers who have something in common. Such customers have a total of about $680 billion in deposits at credit unions.

In reality, the strength of the tie between what customers of credit union members have in common has declined for years. For example, I am a member of the Security Services Federal Credit Union, despite the fact that the only paying jobs that I have ever held in my life have been as a newspaper delivery boy, as a freight unloader in a university kitchen, as a tutor, as a math homework grader, as a continuing education instructor, as a professor, as a reporter and as a lawyer, none of which rightly qualify as security services unless you include the occassions when I've acted as bouncer at law firms where I have been employed. But, they remain member owned and tend to be more conservative in their lending and investments than commercial banks.

The NCUA put five wholesale credit unions into receivership as a result of the financial crisis. The Wall Street Journal, summed up the impact of those receiverships, three of which took place in September of 2010, and the other two of which were earlier.

Bad bets on mortgage-backed securities have now killed five of the nation's 27 wholesale credit unions since March 2009. The federal government, which now controls about 70% of the total assets at such credit unions, said the surviving institutions will be reined in so that they take fewer risks with their investments. . . . Members United Corporate Federal Credit Union in Warrenville, Ill., Southwest Corporate Federal Credit Union of Plano, Texas, and Constitution Corporate Federal Credit Union, Wallingford, Conn., which had a total of $19.67 billion in assets as of July, were taken into conservatorship by federal regulators. . . . Since the start of 2008, 66 retail unions have failed, compared with more than 290 banks or savings institutions. . . . Last year, regulators seized the two largest wholesale credit unions, U.S. Central Federal Credit Union, based in Lenexa, Kansas, and Western Corporate Federal Credit Union, San Dimas, Calif., after finding their losses were much larger than previously reported.

Losses on the mortgage-backed securities held by the five seized credit unions are expected by regulators to total about $15 billion. Wiping out the capital of the failed institutions will cover a chunk of those losses. But the remaining $7 billion to $9.2 billion eventually will be passed along to the nation's 7,445 federally insured credit unions in the form of future assessments.

The total number of failed banks and S&Ls has now risen to more than 350.

The $50 billion of mortgage backed securities bought by the wholesale credit unions which placed into receivership are now worth about $25 billion. WesCorp, which had 74% of its investments in mortgage backed securities has suffered a 31% on its mortgage backed security portfolio, the other four wholesale credit unions suffered losses of 10% to 16% on their mortgage backed securities portfolio which made up 31% to 57% of their respective portfolios of investments.

Of hundreds of bonds inherited by the NCUA in its rescues of wholesale credit unions, many were packed with subprime mortgages, interest-only loans or mortgages with other risky characteristics such as not requiring income verification. The mortgage-backed securities often carried Triple-A credit ratings at first. Many now have junk ratings.

Now, the NCUA and other federal agencies stuck with the bad loans are threatening suits to strike back at the investment banks that overhyped these mortgage backed securities:

The NCUA is accusing Goldman Sachs Group Inc., Bank of America Corp.'s Merrill Lynch unit, Citigroup Inc. and J.P. Morgan Chase & Co. of misrepresenting the risks of the bonds to wholesale credit unions. . . . agency officials recently issued an ultimatum to several firms that churned out the bonds: Either refund every dollar spent to buy the bonds when they were issued or face lawsuits seeking to recover the money. In a securities filing this month, Goldman said the NCUA "has stated that it intends to pursue. . . on behalf of certain credit unions for which it acts as conservator" claims that offering documents for certain securities Goldman sold "contained untrue statements of material facts and material omissions."

The NCUA claim is the classic securities fraud 10b-5 suit. The NCUA is claiming that the investment banks had to lie in very specific disclosure document in order to sell their bonds.

But, the economics involved in a securities fraud suit against an investment bank based on bond issuances are very different than the economics involved in the more typical securities fraud suit against a corporation brought by shareholders of that corporation based on stock issued long ago and were trading in the secondary market when the person who is suing bought them.

In a suit by a bondholder, the situation is very similar to an ordinary fraud suit where someone selling something lies about it to make a sale in exchange for immediate payment in which the seller has a direct and immediate financial interest. And, the pot of money from which recovery is sought is different from the one owned by the people bringing the suit.

The FDIC, the Treasury and the Federal Reserve, each of which holds similar securities acquired in the course of the bailout for which similar representations were made could bring similar suits.

[T]he Federal Deposit Insurance Corp.'s board has authorized the filing of lawsuits seeking to recover more than $3.5 billion from officers and directors at failed U.S. banks.

Last week, the FDIC accused the wives of Washington Mutual Inc.'s two top executives at the time of the big thrift's 2008 collapse of illegally moving cash and houses into trusts to shield the assets.

The executives called the suit seeking over $900 million baseless. . . .

Last year, the FDIC took over as plaintiff in a suit filed by Riverside National Bank of Florida, a bank in Fort Pierce that, before failing in April, had stuffed its portfolio with 27 collateralized debt obligations, or slices of bond pools. Riverside accused more than a dozen firms of misrepresenting the CDOs' value. At the time the FDIC stepped in, it owned parts of over 250 CDOs bought by small banks that subsequently failed.

Of course, investment bankers were the only one's at fault:

In November, an audit by the NCUA's inspector general concluded that the management and board of one wholesale credit union, called Western Corporate Federal Credit Union, or WesCorp, didn't properly manage the risk of its portfolio and bought too many mortgage securities. . . . The inspector general's review didn't analyze the possible role of underwriters, issuers or credit-ratings firms.

It isn't entirely clear from the newspaper report whether the investment banks were acting and underwriters or issuers in these sales. Credit ratings themselves are considered "opinions" which do not give rise to fraud liability, even though most bond traders rely on those ratings almost completely to the exclusion of prospectuses, and even though a triple-A rating was in fact completely inappropriate for securities that were as risky as the entire class of mortgage backed securities that were issued actually were in hindsight.

Establishing that facts in the prospectus were false or that facts existed that were omitted from the prospectus, and that those facts had a material impact on the value of the securities, is generally straightforward legally now that investigations have revealed what when wrong with these securities.

The unknowns in suits against investment banks are establishing that the investments banks a the proper parties to sue, rather than special purpose companies set up to issue the securities, because securities laws do not generally recognize "aider and abettor" liability for securities fraud. And, the party bringing the suit also has to establishing "scienter" at the time that the prospectus containing material fact or omitting material facts was prepared. In other words, it isn't enough to show that a statement included a false statement or omitted a material statement, the suit has to show that the company making the statement knew at the time that it was stating something that was untrue and material, or omitting a fact known to be material.

In defending the suits, the investment banks can either claim that it didn't know about the ugly details, or that they believed that the facts were not material because features of the bonds like guarantees from loan originators and credit default swap derivatives made problem with the underlying bonds irrelevant, and nobody realized that "counterparty risk" in these guarantees was as serious as it actually turned out to be in hindsight.

If a court finds that they lied, the investment banks are on the hook and their newfound post-financial crisis profits could evaporate. But, if a court finds that they weren't aware of the problems with their prospectuses, then they are off the hook. Post-financial crisis investigations which seem to show that there were insider communications showing that insiders at major investment banks knew that mortgage backed securities were really junk weaken the case of the investment banks on the merits, if they are not mere "aiders and abetters." Revisions to the bankruptcy code made in 2005 also makes it much harder for investment bankers found to have lied to protect their assets from those who prevail in securities fraud lawsuits.

Moreover, if one federal agency prevails in a securities fraud suit from a particular bond issuance, and appellate courts set precedents that clear legal obstacles to that theory of recovery by affirming those wins, other federal agencies and private bondholders who took losses in the same or similar deals can walk into court using the doctrine of collateral estoppel to apply the first winner's success to their own cases, leaving little more to be proved. As a result, there are huge incentive beyond those in these particular NCUA lawsuit for the investment banks to settle the cases to avoid setting a precedent to could be applied in many other cases.

Thus, it is very likely that the investment banks will have to pay record settlements that reduce taxpayer and innocent investor losses at the expense of the investment banks before the aftermath of the financial crisis is complete.

READ MORE - Feds Take Aim At Investment Banks

Daylight savings time and other annoyances

* So, we're back on daylight savings time, which takes more of the year than standard time. Daylight savings time is like the ultimate popular kid stunt: "I can make the entire country pretend its an hour ealier than it really is, just because I can get everyone to agree with me." And, of course, once it takes off, you really have no choice but to go along. Still, losing an hour in the spring is brutal.

* Washington Park in Denver has a special magical glow that keeps it attractive regardless of what is going on in the outside world. But, I'm beginning to think that it may be a force field instead. I've been trying to stop paying $17 a month for free TV by setting up an antenna. Before I started getting basic cable, I'd tried it from a powered antenna inside my living room and get one or two channels. This weekend, after going to the trouble of setting a powered antenna up on the highest point on my roof, I got absolutely zero reception. Needless to say, I am not very impressed with the digital broadcast TV revolution, although it may simply be that Wash Park is as much of a TV dead zone as it has a reputation for being a cell phone dead zone.

* Another of the great mysteries of life is why old computers accumulate problems. They produce stray, seemingly meaningless error messages. They slow down. Virus scans and disk defragmentation stops helping. It might be possible to remove accumulated programs, but who knows what it is safe to remove. It reaches the point where you'd like to just run the restore disks and start over, but of course, by that point you've invested money in programs and misplaced the restore disks and the original programs with their access codes.

* Then, of course, there are the dreaded smart phones. I held out for the longest time. But, finally, about three years ago, I had to give in because it was expected that you have access to e-mail at all times for work. But, every now and then, you have to change phones, and the switch is painful. It takes weeks to get it back to the unsteady compromise that you have with the machine before you switched, when you knew how to work what you needed and it all worked smoothly.

* My daughter embarks on the brave new world of Home Economics (or whatever they call it these days), today. Rumor has it that the cooking agenda is full of things that we would never actually cook in our own house for want of nutritional value, but such is life. Hello Hamburger Helper(R)!

* The 8.9 magnitude Earthquake which initially seems to have spared Japan too much damage, now seems to have actually inflicted a Katrina class blow as more news reaches the world.

* The situation in Libya is getting ugly, as Kaddafi and the rebels civil war. (On the bright side, the monarch of Oman appears to be ready to convert from an absolute to a constitutional monarchy in the next thirty days.)

* Japanese manga and anime make frequent use of images and scenes that draw on the characters of the real story, but rather than being blubs are just riffs on the concepts that aren't part of the story itself, something quite rare in American media (as is the habit of having the author reserving space to directly address the audience). Is there a general name for these extraneous sketches?

* Why do the Denver Assessor's office have a nice online interface for its records, while the Denver Clerk and Recorder's office, which is just as automated, does not have its grantor-grantee index and file images available online? Both are public records. I suspect it is so that the clerk's office can make us pay 25 cents a page for copies and make title companies pay for bulk downloads to escape that problem. But, I'd surely favor any candidate in the current clerk and recorder's race who would promise to put the grantor-grantee index online.

* Some days, you think humanity is on the right track. Some days, you read the news from Cleveland, Texas (mass child molestation of eleven year old in a small town capture on cell phone video), and you are rather less hopeful. Ironically, the crime of taking the video will probably garner stiffer sentences than the underlying crime itself.

* For reasons mysterious to me, a wave of male enhancement product spam is deluging this blog at the moment, I am trying to review new comments an delete the bad ones a rapidly as I can. I still don't see why it is so hard for regulators to determine who the vendors being advertised are, trace them with sample transactions, and use the vendor records to shut these people down. It really is just a handful of industries that leave the bulk of them, and apparently there are not that many spam purveyors out there comprising the bulk of the traffic. They money trail ought to be auditable. Maybe all those SEC employees who were using government computers to watch porn could do it as a form of community service.

* We are about to celebrate Saint Patrick's Day (indeed, many people did this past weekend), after the man famous for converting the pagans of Ireland to Catholicism. Garrison Keillor's show this weekend (part of the show, apparently originally from 1997 are here) explained why this makes quite a bit more sense than celebrating Saint Olaf's day, something riotously funny to a fellow ex-Lutheran. But, in an era of anti-imperialism and distrust of institutions, why not celebrate Saint Francis of Assisi Day instead? (He has a Saint's Day on October 4, but it isn't all that big a deal.) Perhaps Saint Francis Day could be substituted for ever more controversial Columbus Day (October 12), as a day of Italian-American pride.

* The newspaper comics this weekend also posed the ultimate elementary school boy query for March: In a battle between ancient Romans (associated with the Ides of March) and Lepricauns (associated with Saint Patrick's Day) who would win? The particularly frightening aspect of this query is that there is apparently now a television show devoted to such questions, asking in a recent episode with quasi-scientific rigor, who would win in a fight between the Musketeers and the Manchu warriors (whose ancestors apparently have formed an immigrant community to the north of Denver).

* Also, in hopeful news, the Denver Post has reiterated its support for abolishing or narrowing the scope of the death penalty in Colorado. Narrowing the scope of first degree murder to exclude neo-natal homicide by women in the throes of childbirth and felony murder that does not involve triggermen or people who have solicited a murder would be a good start, and if applied retroactively, would improve the state of the state budget and greatly reduce the ranks of juveniles serving life without parole in the state.

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