Entity theory as myth in the origins of the corporate income tax.

• Author: Bank, Steven A.

INTRODUCTION

The United States has long operated under a dual system of business taxation in which corporations and partnerships receive disparate treatment. Corporations are treated as separate taxable entities, while partnerships are ignored for most purposes. Perhaps the most notable impact of such disparity is that income from businesses operating in corporate form is taxed twice--first at the corporate level when earned and a second time at the shareholder level when distributed. Income from businesses operating in partnership form, however, is taxed only at the partner level. (1) This dual system has frequently been called unfair and inefficient, (2) but Congress has addressed only its symptoms. (3) The source of the problem can be traced back over one hundred years to the adoption of the first separate corporate income tax. (4)

The traditional explanation for the original adoption of a corporate income tax is that developments in entity theory led Congress to consider the corporation, but not the partnership, as a taxpayer or "entity" separate from its owners. During the Civil War and Reconstruction, the use of corporations was still relatively limited and the line between corporations and partnerships was blurred by the spread of general incorporation acts. Consequently, observers suggest that the Tariff Act of 1864, (5) which treated both corporations and partnerships as conduits for purposes of the country's first income tax, was a reflection of the view that the corporation, like a partnership, was little more than an "aggregate" consisting of its shareholders. (6) By the end of the century, however, the partnership view of the corporation became increasingly inconsistent with the rise of the large corporation. Academic theorists began to agonize over the legal personality of the corporation. (7) During the debate over the 1894 Act, this abstract and theoretical question seemed to take on great practical importance. (8) According to modern observers of this debate, it was the acceptance of the view that the corporation was itself a separate taxable entity that led to the adoption of a corporate income tax in 1894 (9) and laid the groundwork for the later imposition of double taxation. (10)

This explanation overstates the role of entity theory in the development of the dual system of taxing business income. Throughout the nineteenth century the corporation was viewed as a separate entity, capable of being taxed on its income on the same basis as an individual. This was especially true during the Civil War and Reconstruction when the 1864 Act was in effect. States taxed corporations as separate entities both before and after the Civil War and the Supreme Court upheld the separate entity status of a corporation in several state tax cases decided soon after the 1864 Act was instituted. (11) The aggregate theory of the corporation was not discussed until well after the adoption of the Civil War income tax acts. Although Congressional debates over the 1894 Act were animated by discussions regarding the nature of the corporation, (12) entity theory was merely one of several rationales offered to justify a corporate tax rather than a legitimate change in the understanding of the corporation. (13) Moreover, Congress made no attempt to subject corporate income to double taxation in either 1864 or 1894. Thus, there is little basis for the notion that the adoption of a corporate income tax, and the subsequent adoption of double taxation, was the result of a late nineteenth-century vision of the corporation as a separate entity.

If corporations were not taxed because they were considered separate entities, why were they taxed? This Article will establish that the corporate income tax was originally adopted as a substitute or "proxy" for taxing corporate shareholders directly. The rise of intangible wealth and the increasing tax evasion associated with this new wealth led Congress to search for alternative methods of reaching the income of wealthy individuals. Because of its regular and open distribution of dividends, the corporation was an obvious target for an expansion of stoppage-at-the-source collection efforts that had proven so successful during the Civil War and Reconstruction. In effect, the corporate income tax was thought to be a necessary mechanism for enforcing a comprehensive scheme of individual income taxation.

Part I compares the federal taxation of business income during the 1860s, the 1890s and beyond, highlighting the continuing efforts of Congress to avoid double taxation. Part II outlines the growth of the corporation and the development of entity theory in this country in order to rebut the traditional view of its importance in the development of the separate corporate tax. Part III explains how the differences in the treatment of corporations under the 1864 and 1894 Acts are attributable to an increased interest in taxing shareholder income and explains why this interest did not extend to taxing partnerships as well. The Article concludes in Part IV with a discussion of the possible reasons our current corporate income tax has strayed so far from its origins as a tax on shareholder income.

1. EARLY FEDERAL REVENUE LAWS AND THE AVOIDANCE OF DOUBLE TAXATION

   1. Civil War and Reconstruction

      1. 1862 Act

         In the face of mounting debt and a pressing need for funds to help finance the war effort, (14) a federal income tax was first collected in 1862. (15) The 1862 Act imposed a tax of three percent on all income between $600 and $10,000 and a five percent tax on incomes in excess of $10,000. (16) Although the Act did not specifically mention income from corporate or partnership profits, it did impose a form of withholding tax on certain businesses. A tax of three percent was levied on all dividends issued and interest paid by railroad corporations and a similar tax was assessed on all dividends issued and on all sums added to surplus by banks, trust companies, savings institutions, and insurance companies. (17) Despite the inclusion of these provisions in a separate section, they were generally regarded as a part of the income tax. (18)

         Although the simultaneous enactment of an income tax on individuals and a dividend tax on businesses could have been structured to impose a double tax burden, Congress actively sought to avoid this result. Double taxation was a particularly sensitive charge for supporters of the income tax. As Representative Justin Morrill noted when introducing the bill on behalf of the Ways and Means Committee, one of the principal concerns regarding the general income tax was that it hardened wealth that was already taxed by another jurisdiction. (19) In protesting a related provision, one representative typified these concerns by declaring "I do not think that the Government should derive double taxation from the same property for the same period of time. That is a proposition, the correctness of which I think every member will concede." (20) Others confirmed this statement, calling double taxation "not just" and proposing amendments to avoid this result wherever appropriate. (21)

         Not surprisingly, given this anti-double-tax sentiment, Congress enacted measures to minimize the double tax risk in the business context. Principally, shareholders and bondholders were permitted to exclude from their income the receipt of dividends and interest from corporations already taxed under the Act. (22) This, of course, was not a perfect solution. Unlike the income tax itself, the rate was not graduated and there was no exemption for shareholders with incomes below $600. (23) While the latter problem was controversial, (24) albeit rare in occurrence, (25) the former problem was partially alleviated by administrative practice. George S. Boutwell, the first Commissioner of Internal Revenue, issued a regulation instructing the assessors of the income tax to assess an additional two percent tax on individuals with income in excess of $10,000 who received dividends and interest from taxable corporations. (26)

         The 1862 Act did appear to impose a separate tax upon certain corporations in the form of a gross receipts tax. Under section 80 of the Act, businesses operating railroads, steamboats, and ferry boats were required to pay a three percent tax on the gross amount of their receipts. (27) The provision, however, applied regardless of whether the business was incorporated. (28) It also explicitly permitted the affected company to pass along the amount of the tax to their customers in the form of higher fares. (29) Thus, if the business chose to pass on the tax, it was arguably more like a sales tax than a tax on the business itself. Even if it paid the tax without raising rates, however, it was still more similar to a proxy tax because shareholders were entitled to exempt from income the receipt of dividends from corporations subject to the gross receipts tax. (30)

      2. 1864 Act

         Between 1862 and 1864, the country's financial position worsened and the public debt grew to over $1 billion. (31) Revenue from the 1862 Act had been disappointingly low; (32) Congress focused more of its efforts on the income tax in hopes of bolstering its financial condition. (33) Under the 1864 Act, (34) Congress increased the individual income tax rate to five percent on incomes between $600 and $5000, seven and one half percent on incomes between $5000 and $10,000, and ten percent on incomes in excess of $10,000. (35) Unlike the income tax provisions in the 1862 Act, which did not mention income from corporate or partnership profits, the 1864 Act specifically included them in income. Under section 117 of the 1864 Act, "the gains and profits of all companies, whether incorporated or partnership, other than the companies specified in this section, shall be included in estimating the annual gains, profits, or income of any person entitled to the same, whether divided or otherwise." (36) The Commissioner...