Taxation of Private Enterprises

1
Taxation of Private Enterprises

• Presentation to
• Presidents Advisory Panel on Federal Tax Reform
• David J. Shakow
• Professor Emeritus, University of Pennsylvania
  Law School
• Director, KPMG, LLP

2
Taxation of Businesses

• Businesses that are not sole proprietorships are
  generally taxed in one of three ways
• C corporations (separately taxed)
• S corporations
• Partnerships (generally including LLCs)
• S corporations and partnerships are taxed under a
  passthrough structure their owners are taxed
  as if they had earned the entitys income
  directly
• Since the IRS has allowed LLCs to be taxed as
  partnerships, there has been a movement towards
  using the partnership form for small businesses

3
Partnership Taxation

• The partnership tax rules provide much
  flexibility
• This allows the tax law to properly tax many
  different kinds of transactions
• The flexibility of the partnership tax rules has
  also allowed them to be used in the past in tax
  abusive transactions
• To prevent this, Congress has added more and more
  complex rules to the partnership structure

4
Problems with Partnership Taxation

• Complicated partnership tax rules apply to simple
  partnership transactions, not just complicated
  ones
• Sale of a partnership interest
• Redemption of a partner
• Transfer of partnership property to a partner
• Anecdotal evidence strongly suggests that these
  rules are not complied with by smaller
  partnerships

5
ALI Study - Basics

• The ALI reporters study tried to deal with this
  situation in a number of ways
• It accepted Congresss distinction between
  publicly-traded entities and other entities
• No matter their form, publicly-traded entities
  are taxed as C corporations
• Publicly-traded entities are free to choose their
  form for state law purposes without affecting
  Federal taxation

6
ALI Study - Proposal

• The ALI study extended this concept to
  privately-held entities no matter their form for
  state law purposes, they are taxed the same way
  for Federal tax purposes
• It chose the passthrough structure for
  privately-held entities
• Each owners income is taxed at the owners tax
  rate, not at a rate determined by the success of
  the entity
• There is no essential distinction between sole
  proprietorships and other privately-held entities

7
ALI Proposal - Specifics

• The ALI study continued to apply the full set of
  partnership tax rules under current law to
  entities that needed flexibility in their
  operations
• The study concluded that entities owned solely by
  domestic individuals, who divide all income and
  losses in a straightforward manner, could be
  governed by a simpler set of rules
• Starting from that conclusion, it developed a
  simplified system for passthrough treatment that
  does not pose the major compliance burden of the
  partnership tax rules
• The system looks very much like current
  Subchapter S

8
Transition Alternatives

• This new structure could be applied only to
  newly-created entities
• It could be applied to all existing entities
• Entities currently not taxed as passthroughs
  could be treated as liquidated. The resulting
  tax liability could be
• Forgiven
• Taxed at a lower rate
• Payable over time
• Some combination of the above
• Entities currently not taxed as passthroughs
  could be moved to that system over time
• You must compare the imprecision of transition
  rules to the inefficiencies of current law rules

9
Taking the Next Step

• The current dichotomy between separately-taxed
  corporations and passthrough entities is further
  exacerbated by this proposal
• If the Commission supports this step, it could
  consider the advantages of eliminating the tax at
  the level of publicly-traded entities
• This could be accomplished by taxing owners of
  such entities on the change in value of their
  publicly-traded interests

10
Areas for Further Consideration

• How are tax-exempt owners to be treated?
• How are foreign operations (subject to taxes in
  foreign jurisdictions) to be taxed?