Taxing big uncorporations

Larry Ribstein —  7 May 2011

A few days ago Paul Caron summarized moves toward corporate taxation of pass-through entities with more than $50 million gross receipts, adding links to prior posts on this subject.

Today’s WSJ echoes this story, quoting Sen. Max Baucus, Senate Finance Chair: “We’re talking about business income here. Why not have the large pass-throughs … pay a corporate rate?”

Well, here’s “why not”:  Changing the tax on pass-throughs could significantly reduce governance efficiency and may not produce that much more revenue.

As detailed in my Rise of the Uncorporation, an important uncorporate feature is their emphasis on owner “exit,” in the form of distributions and buyouts, over corporate-type monitoring such as boards of directors, shareholder voting and fiduciary duties.  Recent financial crises have shown the problems with corporate-type management, even after decades of reform.  This should encourage openness to alternatives, including uncorporate management. But corporate taxation, by taxing income both when earned by the corporation and when distributed to owners, effectively penalizes the distributions and buyouts that are so important to uncorporate governance. 

Instead of increasing the application of the corporate tax we should be asking how expanding the domain of tax pass-throughs could increase efficient uncorporate governance.   As discussed in Rise of the Uncorporation (243-44, footnotes omitted):

Taxing distributions burdens an important aspect of the uncorporate approach to governance. Yet the only way large firms can be publicly held is to fit into a small exception from the rule treating publicly traded firms as corporations. Large firms that want the discipline provided by owner access to the cash need to end-run the tax on distributions by using tax-deductible debt, thereby increasing the risk of costly bankruptcy. This encourages firms to continue to use the corporate form even as the costs of this form increase. * * *

The factors discussed above in this chapter pointing to more use of the uncorporation for publicly held firms eventually might encourage a change in tax policy. As discussed above, the current exception from the corporate tax on publicly traded firms is limited essentially to passive rent collectors such as natural resource and real estate firms. This is probably narrower than the class of firms that could benefit from flow-through partnership taxation and that would seek this taxation under a more flexible rule. For example, mature, slowgrowth firms that get fairly predictable earnings from established brands might derive comparable benefits from a tax rule that encouraged regular distributions to owners.

Congress might accommodate this need for flexibility by drawing the corporate-partnership tax border with a view to encouraging governance structures that mitigate agency costs. Firms arguably should be able to balance the costs and benefits of the tax as they do with other governance devices. In other words, firms’ governance choices should determine the application of the tax rather than vice versa. At the same time, as long as the corporate tax remains, Congress has to restrict firms’ ability to opt out of it. Lawmakers could let firms choose to be taxed as partnerships on the condition that they have substantially adopted partnership-type governance, including committing to making distributions. This would be analogous to the tax code’s approach to REITs in which the application of partnership-type tax turns to some extent on the firms’ distribution of earnings. It also would be consistent with the goal of making statutory standard forms coherent because it would enable firms to mesh tax consequences with their choice of business association.

A full analysis of proposals to tax pass-throughs should look closely at claims about potential revenue gains given likely increased reliance on debt, as well as the efficiency costs of undermining the uncorporate form and increasing bankruptcy costs.

Larry Ribstein

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Professor of Law, University of Illinois College of Law