46 Tax Notes 1067

Tax Notes

FEBRUARY 26, 1990

LENGTH: 1455 words

DEPARTMENT: Current and Quotable (CQT)

CITE: 46 Tax Notes 1067

HEADLINE: 46 Tax Notes 1067 - CURRENT AND QUOTABLE: INCENTIVES TO DISTRIBUTE EARNINGS IS KEY TO CORPORATE INTEGRATION.

AUTHOR: Johnson, Calvin H.

Unversity of Texas

TEXT:

Set forth below is the full text of a February 5, 1990 letter to Ronald A. Pearlman, Chief of Staff for the Joint Committee of Taxation, from Calvin H. Johnson, Arnold, White & Durkee Centennial Professor of Law at the Unversity of Texas at Austin. The letter has been placed in the March 5, 1990, Tax Notes Microfiche Database as Doc 90-1484.

Dear Mr. Pearlman:

After your presentation at the ABA Committee on Formation of Tax Policy in Houston on February 2, you asked me to write you to explain why, after 1986, a large corporation should ordinarily distribute its earnings immediately, even in the face of the double tax on dividends.

The incentives in favor of immediate distribution, explained in this letter, make this an especially propitious time for corporate integration: corporate management has historically opposed integration because it opposes incentives to distribute, but integration would not now create new incentives for distributions. In the absence of accumulation incentives, moreover, proper integration can use dividend relief or partial integration remedies, which are simpler than full integration.

This letter explains why shareholders can expect to do better if earnings are distributed immediately. The incentive to distribute comes from the rate inversion in the 1986 Act under which corporate tax rates are significantly higher than shareholder tax rates: corporations should be distributing earnings as soon as possible to get access to larger after-tax growth rates available to shareholders. The phenomenon also comes from the 'cumulative law of multiplication' and from the repeal of capital gains: shareholders are indifferent as to whether their dividend tax is applied at the beginning or the end of the growth.

Immediate distributions of corporate earnings ordinarily improve the shareholder's situation over a 10-year period for instance. Assume a corporation makes $1. At 34 percent corporate tax rates (post-1986), the corporation makes 66 cents after tax. If it distributes the 66 cents as an immediate dividend, a large group of shareholders (over $171,000 or under $71,000 in taxable income) will pay tax in the 28 percent bracket (or 181/2 cents tax on the 66 cents dividend) leaving them 471/2 cents to invest. If we assume arbitrarily a 10 percent pretax interest rate over 10 years, a 28 percent tax bracket shareholder can expect 7.2 percent growth or (1.072)to the 10th power or a doubling in 10 years and so be left with 95 cents at the end. Algebraically the formulation is (1-T)(1- t)(1+r)to the n power, where T is the corporate tax rate, t is the shareholder's tax rate on immediate distributions, and r the shareholder's post-tax growth rate. (The formulations are drawn directly from Warren, 'Timing of Tax,' 39 Nat. Tax J. 499, 500-501 (1987), which is very helpful.)

The corporation investing internally on the shareholder's behalf cannot do as well. The corporation can expect growth at only 6.6 percent, given the 10 percent pretax assumption and 34 percent tax rate. The 66 cents post-tax earnings grows over the 10 years to only (1.066)to the 10th power or 1.89 times or $1.25. With the repeal of the special rate for capital gains, the $1.25 post-tax earnings are subject to the full 28 percent tax rate whenever distributed for 35 cents tax or 90 cents after tax, which is less than the 95 cents from the immediate distribution strategy.

Algebraically, the formula for the delayed distribution is (1- T)(1mR)n (1-tt), where R is the corporation's after-tax growth rate and tt is the shareholder tax on delayed distributions. The formula for the immediate dividend was (1-T)(1-t)(1+r)to the n power. So long as tt is no less than t, then current distributions will be better than accumulation whenever corporate after-tax return rate R is less than shareholder after tax return rate r. If t (tax currently) is even lower than tt (tax on delayed distributions) -- such when the current distribution can qualify as a redemption -- then the current distributions are even more advantageous.

Avoiding the IRC section 11 tax entirely, such as with interest deductions or a subchapter S election, is certainly even better than the immediate distribution of earnings. The $1 is then subject only to shareholder tax, reducing it to 72 cents, which will grow at shareholder rates to (1.072)10 or $1.44. Algebraically, (1-6)(1+r)to the n power. Avoiding IRC section 11 is also better than corporate accumulations over a long period even if the accumulated earnings were exempted from shareholder tax (such as by reason of the IRC section 1014 step up in basis at death): the corporate accumulation without shareholder tax ($1.25 after 10 years) is less than $1.44. ((1-t)(1+r)to the n power is greater than (1-T)(1+R)to the n power (1-tt), where tt is zero, but T is greater than t and r is greater than R.)

The situation was different before 1986. When corporate T was 46 percent, but shareholder t was 50 percent, then corporate growth (£ 5.4 percent after tax under the continuing 10 percent pretax interest assumption) could be expected to be slightly faster than shareholder growth (£ five percent). Moreover, the accumulation could convert ordinary income tax on redemption and liquidation distributions into capital gain so that tt might be 20 percent, whereas t was 50 percent. One dollar accumulated would be $.54 (1.054)10 (1-20 percent) or 73 cents. ((1-T) (1+R)to the n power (1-tt)) One dollar distributed would be $.54 (.5)(1.05)10 or 44 cents. ((1-T)(1- t)(1=r)to the n power) Before 1986, a large corporation could honestly tell a shareholder to leave the earnings in the corporation, even if the corporate opportunities were worse than the shareholder's. Now the corporation has to do considerably better to overcome the tax handicap (7.2 versus 6.6 percent).

For truly dynastic accumulations pre-1986, accumulation could be even better than avoiding the corporate tax. It took quite a while for the very slightly better corporate growth rate to overcome the double tax, but it could happen especially if tt was a capital gain rate. Assume there is 40 year growth. Accumulation then yields (1- T)(1+R)to the n power (1-tt) or .54(1.54)40 (1-.2) or $3.54, whereas deductible distributions yield (1-t)(1+r)to the n power or .5(1.05)40 or $3.52. If the distribution is post death, moreover, then tt can be zero, resulting in $4.42 final position. Corporate access to even slightly better investments would improve the accumulation advantage. The long-term growths are certainly not the whole of the market, but they gave some ambiguity to the corporation's choice between stock and debt. The 1986 Act ended that ambiguity.

In any event, the most dramatic effect of the 1986 Act was not in the choice between debt and equity as a matter of initial capitalization, but in the change in incentives as to what an existing corporation should do about existing accumulated earnings or other shareholder equity. Andrews' ALI study (see Andrews, Reporter's Study Draft (Supplemental Study), ALI Fed. Income Tax Project (June 1, 1989)) and the allied Warren study (Warren, 'Recent Corp. Restructuring and the Corporate Tax System,' Tax Notes, February 6, 1989, p. 715)) and Joint Committee on Taxation study (Federal Income Tax Aspects of Corporate Financial Structures, (Comm. Print, Jan 18, 1989)) treat disincorporation distributions as the organizing factor. For them, 1986 was the dramatic event. For somebody like Graetz (Graetz, 'The Tax Aspects of Leveraged Buyouts and other Corporate Financial Restructing Transactions,' Tax Notes, February 6, 1989, p. 721)) who views the debt-equity distinction as the explaining factor, 1986 was less dramatic, although it did reinforce a drive toward debt.

The ALI proposal implicitly assumes that the incentives for distribution would be neutralized if all distributions bore a tax burden (at either shareholder or corporation level) equal to the tax burden on dividends. This presentation shows that distribution incentives remain even if all distributions are subject to the burdens of shareholder dividend tax, so long as shareholder after-tax returns are higher than corporate after-tax returns.

Please call on me if I can provide any further help or information on this issue.

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Sincerely,

Calvin H. Johnson

Arnold, White &

Durkee Centennial

Professor of Law

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