FEDERAL TAX POLICY AND THE STATES: CORPORATE INTEGRATION JAMES W. WETZLER*

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1 FEDERAL TAX POLICY AND THE STATES: CORPORATE INTEGRATION JAMES W. WETZLER* An odd feature of our fiscal federalism is that state and federal governments each make tax policy with little concern for, and sometimes little knowledge of, the impact of that policy on the other s tax system. Often, this impact is sufficiently important that its neglect leads to flawed, or at least poorly understood, tax policy. This paper considers the interaction between federal and state tax policy in two related areas. The first, the integration of personal and corporate income taxes to reduce or eliminate double taxation of corporate-source income, is an area where federal policy has been debated without discussion of significant state tax impacts. The second, limited liability companies, is an area where the federal government has effectively delegated an important federal tax policy to the states, who are acting on the basis of parochial state concerns. CORPORATE INTEGRATION On no federal tax policy issue has there been more discussion and less action than corporate integration. What is rarely noted l Commlssloner of Taxation and hance, New York State, Al- bany, NY is that the various integration proposals would have dramatic and varying impacts on state corporate and personal income taxes. There are essentially five approaches to integration. The dividends paid deduction would eliminate double taxation by wiping out the corporate-level tax, while the gross-up and credit approach would do so by converting the corporate-level tax into a withholding tax similar to withholding on wages and salaries. The partnership approach would treat corporations like partnerships so that there would be no entitylevel tax and shareholders would pay tax on their share of corporate income and deduct their share of corporate losses. The dividends received exclusion would wipe out the shareholder tax on dividends, while the comprehensive business income tax would augment the dividend exclusion by eliminating corporate-level interest deductions and exempting interest income received by lenders. I will examine the impact of each of these approaches on state taxes.* State tax impacts arise primarily because states base their personal and corporate income taxes on federal definitions, so that 393

2 their taxes change whenever federal taxes change. Some states start their personal income tax calculation by using either federal adjusted gross income or federal taxable income; others compute state tax as a percentage of federal tax. States also base their corporate income taxes on federal taxable incoime. States can decouple from federal definitions, but nonconformity adds to complexity and sometimes is infeasible for that reas,on. A federal dividends paid deduction would directly reduce the tax base of states that use federal taxable income as the starting point for their state corporate income tax computation. If, as expected, corporations respond to the dividends paid deduction by increasing their dividend payout, the personal income tax base would expand for those states that use federal adjusted gross or taxable income, or federal tax liability, as the starting point for the state tax calculation. The lost corporate tax revenue in any state would depend on the amount of corporate-source income deemed earned in that state under the applicable apportionment formula. The additional personal income tax revenue in any state would depend on the dividend income of that state s residents. If all corporate taxable income were distributed, states would no longer be taxing corporate income under the source principle. Most states would experience a net revenue loss. Under the giross-up and credit approach, the corporate tax would remain intact, but shareholders would increase (or gross-up) their taxable dividend by the amount of corporate tax deemed paid on the income underlying the dividend and claim a tax credit for that amount. While the gross-up and credit can be designed to be substantively identical to the dividends paid deduction at the federal level, the state tax impacts would be quite different. The state corporate tax base would remain unchanged under the gross-up and credit, while the state personal tax base would be increased by the amount of the gross-up for those states that use federal adjusted gross or taxable income as their starting point. Thus, the dividends paid deduction would lead to a net reduction in state tax on corporate-source income, while the gross-up and credit would lead to a net increase. This difference between the two approaches wocild seem to be at least as important as the relatively technical differences that have been noted in the vast literature on the subject-their relative complexity and the ease with which they can be adapted to exclude tax-exempt shareholders and foreigners from the benefits of integration. The Bush Administration Treasury Department, for example, indicated a preference for the gross-up and credit approach over the dividends paid deduction. Would that preference have survived an analysis of the differential impact on state tax burdens? States may not feel (obliged to remain in conformity with federal provisions whose impacts they deem undesirable, although decoupling will be easier in some cases than in others. It would be a relatively simple matter for states to decouple from a federal dividends paid deduction; however, it would be more difficult for states to decouple from a dividend gross-up, because decoupling would require tediouis calculatlons by taxpayers. The partnership approach to integration is generally rejected oni grounds of excessive complexity, but it is useful to contemplate its impact on state taxes. Eliminating altogether a federal entity-level tax on corpora-, tlons would leave states with no federal tax on which to base state corporate income taxes. How states would respond to this loss IS an open question. Some may abolish their entity-level taxes; others may retain them, although one might expect uniformity to suffer from the lack of a federal model for states to use. Whatever the 394

3 CORPORATE INTEGRATION I outcome at the entity level, the partnership approach would produce some offsetting state revenue gain in states with personal income taxes, because the state personal income tax base would expand by the inclusion of corporate retained earnings in taxable income. This expansion would benefit states to the extent shareholders are residents, because states would generally not be able to tax nonresident shareholders on corporate-source income earned in that state. The dividends received exclusion would leave the corporate tax base unchanged and would narrow the personal tax base by the amount of excluded dividends, thereby reducing state revenues. States could decouple and continue to tax dividend income under their personal income taxes, but enforcement could be difficult because the IRS may curtail or terminate its document matching program for dividends in the absence of a federal tax on those dividends. The comprehensive business income tax, first introduced in the Treasury study, would augment the dividends received exclusion by treating interest the same as dividends and by extending that treatment to interest paid by noncorporate businesses. Denying interest deductions would expand both the corporate and personal income tax bases, while excluding interest and dividend income would narrow the personal income tax base. The expansion of the corporate tax base would be related to how much business income is deemed to be earned under the applicable apportionment formula in each state, while the reduction in the personal income tax base would be related to how much dividend and interest income is received by residents of each state. As with dividends, elimination or curtailment of federal document matching for interest income would reduce compliance for any state that chose to decouple from the interest-received exclusion. Thus, the various corporate integration proposals would have very different impacts on the level of state taxation of corporate-source income, the complexity of those taxes, and the distribution of the tax base among states. These impacts on state taxation are sufficiently meaningful that they should inform future discussion of corporate integration, especially discussion of the relative merits of the various approaches to integration. LIMITED LIABILITY COMPANIES The proliferation of limited liability company (LLC) laws represents the mirror image of the corporate integration debate. Here, state actions are driving federal policy without any meaningful discussion of the impact of those actions on legitimate federal policy concerns. An LLC is a new type of entity, created pursuant to state law, that combines the flexibility of the partnership form of organization with limited liability for all LLC members. While there are a number of more or less technical differences, LLCs are basically 5 corporations without the limits on the number or characteristics of shareholders or the restriction to one class of stock. However, like 5 corporations, LLCs may not be publicly traded. Under a 1988 revenue ruling, the federal government generally taxes LLCs as partnerships. States are busily passing laws authonzing LLCs In their state. Pressure on states to enact LLC laws comes from a desire to enable their businesses to take advantage of the opportunity to have limited liability without the federal tax penalties of corporate status and from fear that, otherwise, the businesses will move to states that are more accommodating. States are not motivated by concern over the federal tax impact of LLCs or other federal policy considerations. The LLC phenomenon, a creature of state 395

4 laws and an IRS revenue ruling, will have a major impact on federal tax and financial policy. Once most states enact LLC laws, taxable owners will generally not form privately held C corporations because LLCs will provide vtrtually all the nontax advantages of corporate status with more favorable tax treatment. This will create a significant federal revenue loss, because privately held C corporations pay significant corporate income taxes and, unlike LLCs, cannot pass losses through to shareholders.3 Some existing C corporations, for whom the corporate and personal income taxes on liquidation will be less than the benefit of LLC status, will liquidate and become LLCS.~ As newly formed businesses that otherwise would have been privately held C corporations become a progressively larger share of economic activity, the corporate income tax will evolve into a tax on being publicly traded. This twould be a highly unusual flnancial policy Today, because so much economic activity is conducted by publicly tradecl entities, ordinary citizens can invest in much of the U.S economy on the same basis as very wealthy investors. Once LLCr; take hold, wealthy people will generally be able to invest in privately held entities free of entity-level tax, vvhile ordinary citizens will be limited to investing In publicly tradecl entities that remain subject to tax. Would companies like Microsoft and Apple Computer have gone public had they been able to operate as LLCs? If a world in which nenlly formed privately held entities are untaxed is desirable, why doesn t Congress get us there by eliminating the restrtctions on use of subchapter S? One answer lies in the bias of the federal budget process. Legislation expanding subchapter 5 would be scored (3 revenue loser, while essentially the same result achieved by state law and IRS ruling is exempt from budgetary control. The LLCs, of course, represent a form of corporate integration, albeit one limited to privately held entities and effectively denied to the vast majority of existing corporations because of the tax cost of liquldating. There IS no reason to think that a legislated integration program would be done this way; indeed, the partnership approach is generally viewed as an undesirable way to integrate. So while Washington debates integration without considering state tax impacts, the states are implementing integration for newly formed, privately held entities without consulting Congress and without considering the impact of their actrons on national policy goals. Achieving ltmited corporate integration through state-by-state enactment of LLC laws probably will lead to different state taxation of the income of the integrated enterprises than would any of the federal integration proposals. Most states with LLC laws have chosen to conform to federal tax treatment, often without explicit consideration of the revenue impact. The two states that treat LLCs like C corporations, Texas and Florida, lack personal income taxes so that federal conformity would mean outright exemption for LLC income attributable to LLC members residing in those states. One assumes that a federally generated corporate integration proposal would produce a more diverse state response. Conclusions Clearly, we need better coordination between state and federal tax policies. At the administrative level, this coordination is occurring because the IRS has made a major commitment to coordinating witlh state tax administrators. There needs to be a similar dialogue among policymakers. Federal preemption of state taxing authority, the incentives provided by federal deductions or credits for state talxes, the impact of federal tax changes on the definition of conforming state tax bases and on the incentive for states to conform, the eco-

5 I CORPORATE INTEGRATION nomic impact of federal taxes on state tax bases are all issues where states have a legitimate interest and deserve to be consulted, just as states should consult with federal policymakers when they take actions, like LLC laws, that affect federal policies. ENDNOTES For example, the otherwtse comprehenslve 1992 Treasury study of mtegratlon devoted 267 pages to the subject wlthout once refernng to state tax Impacts See U 5 Trea- sury Department /ntegrat/on of the hdwdual and Corpo- rate Tax Systems, Taxing Bwness Income Once, January 6, 1992 A sixth approach, applymg a lower corporate tax rate to dlstrlbuted Income than to retalned earntngs, which characterlzed the U 5 tax system between 1934 and 1938, would have little Impact on state taxes 3 This discussion reflects the tax law prtor to enactment of the Omnibus Budget Reconciliation Act of 1993, which ~111 have a significant Impact on the attractiveness of the LLC form 4 The New York State Department of Taxation and Finance estimates that approximately 1 percent of existing C corporations In New York have fmanclal charactenstlcs such that It would be worthwhile for them to liquidate and operate in LLC form However, the new rules for amortization of goodwtll could alter that result 397