Taxation of Business Income

Sorry all, but I have another dry tax policy post. This post is in part to respond to some previous comments and in part to make some comments about the proper tax treatment of business income.

Brother Vorms had an interesting take on the dividend tax. I don't disagree with his conclusion, but when we're talking about dividend tax rates we have to remember that the tax code imposes an entity level tax on corporations (i.e., the corporate income tax). Bear with me here.

Federal Tax Treatment of Business Income

Dividends

Say Corporation X made pre-tax profits of $100 last year, and would like to distribute this amount to its shareholders in the form of a dividend. The tax consequences are as follows. The $100 in profit will be taxed at the corporate level at a rate of 35%. The amount left over for the dividend is therefore $65. There is no corporate tax deduction available for a dividend paid to an individual. The $65 dividend payment will then be taxed to the individual recipient at a rate of 15%, leaving a total after-tax payment of $55.25 (65 – [.15 * 65] = 55.25). This gives an effective tax rate of 44.75% on the dividend.

Interest

Say the same corporation has $100 in pre-tax profits before taking into account the payment of interest on debt. Further assume the corporation is closely held, and it owes the debt to the owner. Finally, assume the corporation owes $100 in interest to the owner in the current year.

The interest payment (if the debt is considered bona fide, which is a whole issue unto itself) is a deductible expense to the corporation. So the corporation will face no tax on the $100 of pre-interest profits ($100 in gross income offset by a $100 interest deduction). The interest income is then taxable to the individual owner at ordinary income rates. Assuming the owner is the highest marginal tax bracket (35%), the income will be taxed one time only at a 35% rate. The total effective tax rate is therefore 35%.

This same analysis applies to interest paid to bondholders. Interest on deposit accounts, savings accounts, CDs, money market accounts, etc. is also taxable only once, to the individual payee (i.e., at a maximum rate of 35%). Investors may be able to make more after-tax money by investing in high-dividend stocks than savings accounts or CDs, but this is because the pre-tax rate of return is higher for corporate stocks, not because the overall effective tax rate is lower.

Capital Appreciation

Assume again that Corp. X has $100 in pre-tax profits. Assume that in this case, however, the corporation decides to retain the earnings. The corporation is now holding onto $65 extra in post-tax dollars (remember, a corporation’s profits are subject to the corporate tax), so the value of its market capitalization should theoretically be worth $65 more (not necessarily a true assumption for a large publicly traded corporation, but it is probably true for closely held corporations. Anyway, the assumption is for simplicity’s sake and does not alter the analysis).

Say the owner of Corp. X’s stock (assume there is only one) wants to liquidate his interest after the corporation’s stock increases in value by $65. When he does so, he will face a 15% capital gains tax on the $65 increase in value (in addition to any previous appreciation in value). Concerning the increase in value of $65, he will owe capital gains tax of $9.75 (or a reduction of capital loss worth the same amount), again ending up with $55.25. Just like in the case of a dividend, he will face a total tax rate of 44.75%.

Although the treatment of capital appreciation (in the context of corporate stock appreciation only) and dividends is similar, there are some very important differences from a general policy standpoint. First, the capital gains tax is only imposed upon realization, so in the case of capital appreciation, the taxpayer gets the benefit of deferring the tax until he cashes out (i.e., the time value of the deferred tax amount). Taxes will be due immediately upon receipt of the dividend. So in present value terms, the tax burden on the capital appreciation is lighter. By the same token, however, capital gains can be washed away before the taxpayer cashes out. Dividends are cash in hand. So capital gains may be less desirable in some contexts because the gains are subject to future capital risk. But this is a matter of finance, not tax treatment. Strictly speaking in terms of the government's take, the tax treatment of capital gains is more generous than the treatment of dividends because of the deferral issue.

But the main difference between the two as a matter of general tax policy is that most capital gains are not in the form of appreciated corporate stock. An absolute majority of capital gains are in the form of appreciated real estate. A lot of capital gains reflect appreciated partnership interests or various other noncorporate investments as well. So most capital gains do not reflect income that has already been subject to tax (and recall from my previous post that most capital gains are not taxed at all). Dividends, on the other hand, are by definition (under the tax code, anyway) paid out by an entity that is in fact subject to the corporate tax first. So the reduction in the rate of dividend taxation is far more justifiable than the capital gains preference from the standpoint of ameliorating the “double taxation” distortion (i.e., the tax at the corporate level and then again at the individual shareholder level).

Partnerships, LLCs, and S-Corporations

Partnerships, LLCs, and S-Corps are not subject to an entity level tax. Items of income are allocated directly to partners, members, or stockholders. Therefore, X LP or X, LLC or X, Inc. (subject to subchapter S) will pay no direct tax on the $100 of income. The tax items “flow through” to the partners or shareholders, who will (again, assuming a 35% rate) once again face a total tax rate of 35%. And when an owner of an interest in any one of these entities sells the interest, any resulting gain (which, remember, was not subject to any entity level tax) will be taxed at the 15% capital gains rate.

Economic Distortions

So you can see that dividends are actually the least favorably treated form of business income, even with the 15% tax rate in effect. This is as a result of the separate imposition of tax at the corporate level. Now granted, this analysis is simplified for the purposes of demonstration. It assumes away evasion, mischaracterization, tax-exempt forms of income, and special deductions and credits. As a result of some combination of these factors, along with the fact that of course some corporations do, in fact, have no income in any given year, only 1/3 of all corporations pay any corporate tax at all in any given year. But this fact doesn’t change much.

Say a corporation successfully avoids tax at the corporate level by posting an artificial tax loss, and therefore any dividend payments will only be taxed once, at the 15% rate. But the same thing would happen in the context of capital appreciation: the $100 of income would only be taxed once, at a 15% rate, when the owner cashed out. And of course an S-Corp, LLC, or partnership can just as easily hide or legally exempt income as a traditional C-Corp can, so any income from these investments would never be taxed at all to the individual owners. The only difference is for interest payments, which would still be taxable to the individual recipient at the ordinary income rate (maximum of 35%) whether the corporation had a loss or not. And of course interest paid from a savings account or CD is always taxable at ordinary rates as well. But as long as the corporation paying the dividend has taxable income greater than or equal to the amount of the dividend for the year (which you would think it usually would if it’s going to be paying out a dividend), the dividend faces the highest effective tax rate. Furthermore, if the corporation didn't owe tax on the profits it used to pay out the dividend because the income was tax exempt interest on municipal bonds, the shareholder could have avoided tax altogether by just investing in tax exempt bonds directly.

So the tax code actually creates an artificial distortion against dividend income, not in favor of it. Interest payments are deductible in full by a corporation, while dividends are not; this creates a distortion in favor of debt and against equity. Some commentators say this leads to excessively high debt/equity ratios among American corporations. The taxation of both corporate income and dividends also creates a distortion in favor of corporate retention of earnings, since capital appreciation is not taxable until realized. And because income from corporations is subject to two levels of tax (the corporate level, and then the dividend or capital gains tax), the tax code creates a distortion in favor of partnerships, LLCs, and S-Corporations and against investment in traditional C-Corporations.

It’s interesting to note, though, that for all the howling about the burden of “double taxation,” the difference in tax burden is by no means in a 2:1 ratio; rather it is 44.75% / 35%, or 1.28:1. This is not “double” in terms of the actual tax bite. The use of the term always bugs me for that reason.

For what it’s worth, I personally think an ideal tax world would have no tax at the business entity level, and would simply allow each item of income to “flow through” to the individual owner(s). That said, I would subject such income to very high, progressive, and uniform rates of taxation – regardless of whether it is capital gain, a dividend, or interest, and regardless of whether the entity that paid it is a corporation or an LLC. This would eliminate arbitrary differences in effective tax rates. But since we live in a world that is very far from ideal, and since the corporate and dividend taxes are among the most progressive taxes in town (they only hit the people that own stock), I support the maintenance of both. The top 1% own something like 50% of the total value all outstanding corporate stock, so for now we should keep corporate and dividend taxes as high as possible if we value progressivity over economic purity (which of course I do). The only problem is that under current law we’re letting massive private equity and hedge fund partnerships totally off the hook by not requiring them to pay any entity level tax at all. If we’re going to stick to an entity level tax regime, this makes no sense.

And Vorms is totally right about the timing issue. Rich people do cash out capital gains en masse whenever rates are lowered. Sometimes right-wing economists use the increase in capital gains tax revenue immediately following a capital gains tax cut to support the idea that lower rates actually increase income. This is obviously ridiculous, because the increased revenue just reflects the fact that people have held off to cash out until the lower rates take effect.