Penalty Provisions and Excise Tax

• Pages: 393-416
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

393

Chapter 12

PENALTY PROVISIONS

AND EXCISE TAX

12.01 Introduction

The organizing feature of Subchapter C is that corporate

earnings from operations be taxed twice—once when the corporation

earns them and once again when they are distributed. Historically,

it has been Congress’s intention that both taxes should be at ordinary

income rates. Whether these guiding principles are sound is explored

in Chapter 1. In this Chapter, the focus is on two pe nalty provisions

and one excise tax. All three were enacted in whole or in part to

safeguard this double-tax regime.

It is not true that Congress intended that all corporate earnings

be taxed twice at ordinary income rates. For example, a corporation

might earn income that is taxed at ordinary income rates, but rather

than distributing those earnings as a dividend to its shareholders,

the corporation might accumulate the income, thereby increasing the

fair market value of its stock. The shareholders could then turn that

appreciation into cash by selling this stock, having the corporation

redeem the stock, or liquidating the corporation. All three of these

possibilities might allow the shareholders effectively to receive the

corporate earnings at capital gains rates.

1

Avoiding or deferring the

shareholder-level tax and converting ordinary income into capital

gain are strategies taxpayers have historically pursued.

Suppose instead that the corporation has not yet recognized a

gain because it has not yet sold its appreciated inventory. If it sells

the inventory and distributes the proceeds, the corporation will be

taxed at ordinary income rates on the sale, and the shareholders will

have ordinary income on the distribution (perhaps taxed at

preferential rates). If instead a shareholder sells the stock of the

corporation which has appreciated in value to reflect the

corporation’s appreciated inventory, the shareholder would normally

recognize a capital gain in the absence of any remedial provisions.

Having envisioned that Subchapter C permits circumvention of

the double-tax system, Congress has for many years included two

sets of penalty provisions intended to prod corporations into making

taxable dividend distributions. These provisions are the accumulated

1

In addition, if the corporation instead distributes its income as a dividend,

and there is qualified dividend treatment under § 1(h)(11), the recipient shareholder

is taxed at long-term capital gains rates, even though the dividend is ordinary income.

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PENALTY PROVISIONS AND EXCISE TAX

Ch. 12

earnings tax and personal holding company tax, taxes that may be

levied on the corporation in addition to normal corporate taxes (e.g.,

under §§ 11 and 55). Both pe nalty taxes are intended to encourage

closely held corporations to distribute, rather than accumulate, their

earnings.

Historically, shareholders had a strong incentive to use

corporations to accumulate earnings, because the highest individual

rate exceeded the highest corporate rate. This differential led some

high-bracket individuals to incorporate their businesses and

accumulate earnings at the corporate level until such time as the

individual was in a lower tax bracket. Even when the top individual

rates are lower than the top corporate rates, accumulation may be a

useful strategy. Once a corporation has earned income and paid the

appropriate taxes, the decision whether to distribute or accumulate

is not based solely on any differential between the corporate and

individual rates. Instead, the decision is based partly on the

differential between the tax rate on ordinary income and the rate on

capital gains and partly on the advantages gained from deferral.

If a corporation earns $100 after its taxes, the decision whether

to distribute those earnings is influenced in part by the potential for

deferral. By not distributing, the corporation can invest the $100 and

earn a return that will be taxed once at the corporate level. While it

is true that there may be a shareholder-level tax on the eventual

distribution, the corporation meanwhile earns income on dollars that

would otherwise have been paid in taxes. If instead the corporation

distributes the $100, the shareholders will have $100 minus the

shareholder-level tax to invest.

Historically, what has made this deferral troublesome is the

ability of shareholders to defer distributions until the shareholders

are in lower tax brackets. Or shareholders might be able to convert

ordinary income into capital gain. Moreover, as long as our tax

system allows a step-up in basis of assets at death under § 1014,

taxpayers will have an incentive to defer taxes with a consequent loss

to the Treasury. Suppose a taxpayer holds stock with a $30 basis and

$100 fair market value due to $70 of corporate earnings. Upon death,

the taxpayer’s estate or beneficiary can either sell the stock or have

the corporation redeem the stock without recognizing gain since both

the basis and fair market value of the stock will be $100.

Of course, corporations had the greatest incentive to accumulate

earnings when the highest individual tax rate far exceeded the

highest corporate rate. For example, before 1982, the highest

individual rate was 70 percent, while the highest corporate rate was

just 46 percent. In contrast, between 1982 and 2017, the highest

corporate rate approached and sometimes exceeded the highest