The Corporate Double Tax

• Pages: 1-19
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

1

Chapter 1

THE CORPORATE DOUBLE TAX

1.01 Introduction and History

We have had a corporate income tax continuously since 1909,

longer than we have had a personal income tax. Before enactment of

the sixteenth amendment in 1913, the Supreme Court upheld the

1909 corporate tax as a valid excise tax imposed on businesses

exercising the privilege of operating in corporate form.

1

With the

passage of the sixteenth amendment, the constitutional foundation

of the corporate income tax became secure whether characterized as

an excise tax or as an income tax.

Most rules of corporate taxation are found in Subchapter C.

2

The

subchapter’s basic premise is that a corporation should be a taxpayer

distinct from its shareholders. From this premise follows the central

feature of corporate taxation: the double tax on corporate profits. A

first tax is imposed at the corporate level when profits are earned by

a corporation. The second tax is imposed at the shareholder level

when these profits are distributed by the corporation to its

shareholders. Because the distributing corporation cannot deduct

amounts distributed as dividends, the over-all effect of this system of

taxation is to impose a double tax on distributed corporate profits.

Early on, the Supreme Court dealt the double tax a body blow.

It considered whether a corporation recognized gain when it

distributed appreciated property to a shareholder. Although the

government argued that the corporation should recognize gain on the

distribution as if the property had been sold, the Court concluded

that no gain or loss was recognized at the corporate-level. This rule,

known as the General Utilities doctrine,

3

allowed corporations to

distribute appreciated assets in anticipation of sale, avoiding the

corporate-level tax. The General Utilities doctrine and the

1

Flint v. Stone Tracy Co., 220 U.S. 107 (1911). In Pollock v. Farmers’ Loan &

Trust Co., 158 U.S. 601 (1895), the Supreme Court invalidated the federal personal

income tax as a direct tax requiring apportionment under article 1, clause 9 of the

Constitution. As part of that early decision the Court also invalidated a corporate

income tax too intertwined with the personal income tax to stand on its own.

2

Sections 301 through 386 comprise subchapter C (corporate distributions

and adjustments) of Chapter 1 (normal taxes and surtaxes) of subtitle A (income taxes)

of title 26 [the Internal Re venue Code] of the United States Code. Note that the

Internal Revenue Code is divided into a number of “subtitles,” each subtitle into

“chapters,” each chapter into “subchapters,” and each subchapter into “parts.” Thus,

the study of the code is something like the study of living organisms, with species

replaced by parts, genus replaced by subchapters, and so on.

3

See Section 4.04 infra.

2

THE CORPORATE DOUBLE TAX

Ch. 1

congressional attempts to circumscribe its potential for abuse

influenced much of the early development of subchapter C.

Beginning in 1969, Congress began to erode the General Utilities

doctrine, with its substantial repeal made part of the Tax Reform Act

of 1986. Much of subchapter C has changed as a result, including not

only the taxation of distributions but also the taxation of asset sales

before liquidating distributions and the taxation of purchases of

stock of one corporation by a second corporation. Critics of the

General Utilities doctrine long argued that its repeal would simplify

the Code. In theory they probably a re right, but you will have to

decide for yourself whether the congressional treatment of the repeal

brought simplicity or added complexity.

Historically, distributed corporate profits were taxed as

ordinary income to the shareholders. However, gain from the sale of

corporate stock always has been treated as capital gain. Because the

increase in value of corporate stock often reflects undistributed

corporate profits,

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a shareholder wishing to obtain his share of the

corporation’s profits while avoiding ordinary income could sell his

stock before the corporation declared a dividend. In fact, in many

circumstances the shareholder could sell his stock back to the issuing

corporation and still qualify for capital gains treatment.

5

This

relative favoritism of undistributed corporate profits taxed as capital

gain as compared with distributed profits taxed as ordinary income

has motivated many a taxpayer to avoid dividends in favor of other,

less direct ways of obtaining corporate earnings.

6

You may be surprised to discover that you already know many

of the rules governing the taxation of corporations. Corporations

determine their gross income like other taxpayers. See § 61. Thus,

rents, royalties and interest are taxable to corporations just as to

non-corporate taxpayers, as are gains from the sale or exchange of

property. Similarly, corporations may deduct their ordinary and

necessary business expenses under § 162, their interest payments to

the extent provided under § 163, and their losses under § 165. The

concern of subchapter C—and the concern of this book—is not on the

various rules applicable to corporate and non-corporate taxpayers

alike but rather on those rules applicable uniquely to corporations

4

Stock appreciation can result from market revaluation of the corporation’s

future prospects, from realized but undistributed corporate profits, and from

unrealized appreciation in corporate assets.

5

See Chapter 5 infra. But see § 4501 (adding a one-percent excise tax on

certain stock redemptions and economically similar transactions). The excise tax

under § 4501 is discussed in more depth in Chapter 12.

6

Since 2003, however, “qualified” dividends paid to individuals have been

taxed at the same rate as long-term capital gain. See § 1(h)(11). Nevertheless, a

preference for a stock sale may persist because the gross amount of a dividend is taxed

but only gain in excess of basis is taxed on a sale.