In two recent posts [1] I have criticized the methods by which the state and federal governments tax corporations and how they treat the state-granted limited liability privileges. In this post I will make some proposals as to how best to tax corporations and limited liability companies given their ubiquity in the economy and international nature. While I disagree with the classic complaint about “double taxation” (an inaccurate charge), there are ways to improve the process.

First, recall my biggest issues with the way corporate profits and taxes are handled:

1. Either a corporation is a “separate legal person” from its owners or it is not. If it is a separate legal person, then its financial transactions are with a legal entity other than its owners, and those transactions should be taxed as such.
2. Limited liability, the primary benefit of corporate organization, has societal costs on communities, employees, vendors and creditors, often huge in the event of a bankruptcy. When this privilege is “free,” then we have classic “moral hazards” created. “The society” has the right and obligation to be compensated for assuming those costs.
3. “Income is income.” When government starts giving favorable tax treatment to certain types of income over others, then the “unfavored,” usually those with less political power, are  disproportionately supporting the costs of government. Plus, it makes tax calculation and compliance unnecessarily complicated. The best way to simplify taxes is to get back to “income is income.”

State and federal tax laws have overly complicated the relationship between personal and corporate income, with the 2018 tax law revision making this even worse with new variants of “pass through entities” that will cause tax lawyers to dream up new and creative ways for the rich to avoid taxes.

So, how do we untangle that reality, and tax corporate profits in ways that do not overburden smaller businesses, or make larger ones noncompetitive? My proposal is that we go back to my first two objections above.

Is the corporation really a “separate legal person”?

First, the practical reality is that many small corporations are not really separate legal persons. States have handed out limited liability like candy. I have formed a couple of LLCs myself (note that, counter to common usage, LLCs are not corporations). It is possible, however, to quantify this “separateness” on a scale relating to revenue size, number of employees, and number of owners.

Most of the issues here can be resolved by using a heavily progressive rate on the income of the entity. An LLC with one owner (and the owner only owning one LLC) while making $100,000 in profits is likely not really a separate legal entity from the owner, except for some bankruptcy protection given to the owner by the state. Thus, firms of this size should be assessed at a small marginal rate over personal taxes, even zero for the smallest.

On the other hand, a corporation earning $100 million in profits and having 10,000 stockholders is clearly separate from its owners, and it should be taxed at the same marginal rate as an individual earning that amount of money. If you want “personhood,” then be taxed as a “person.”

How about the issue of dividend versus capital gains income? Using the principle of “income is income,” then the distinction of capital gains income as tax-favored is clearly an invented privilege by the politically-connected elite. Capital gains already have the “time value of money” in their favor, as well as “step-up in basis” upon death, and it needs no additional ones. The distinction needs to go away, with capital gains taxed and assessed whenever the gains are “realized,” at the same rate as regular income. And if you are rich enough to be faced with a huge liability from a capital gains windfall, you are likely rich enough to figure out how to stretch out the receipt of the cash.

Taxpayer-paid failure insurance

The second consideration in setting an appropriate tax rate for corporate income is the value of the “limited liability” that the company is exposing its stakeholders to. This is largely a function of financial liabilities relative to the firm’s assets. Companies with few debts go out of business all the time, but they typically don’t go through more than a pro forma bankruptcy. These are the “soft landings.”

Highly-leveraged companies, however, can go bankrupt in spectacular ways which cause major problems for thousands of “stakeholders” who are not stockholders. Indeed, for up to 25% of private equity buy-outs, bankruptcy is almost a “feature, not a bug” of the LBO process. [2] Corporate tax rates need to reflect the “moral hazard” risk that they place on the rest of society, which would best be an assessment of their risk potential. Think of this as an “insurance premium” tacked onto their corporate tax rate because you, the citizen, are the insurer here, and you ought to be compensated for that.

There are clearly issues that this starting point does not cover, as well as likely new ways to “game the system.” Some corporations, such as Amazon, are masters at generating huge cash flows without showing accounting profits. However, this behavior is partly due to the ingrained nature of tax avoidance in a system that rewards the practice

International corporations present another challenge. However, the approach here is that corporations would be taxed incrementally over “the real persons.” Rates can be adapted to remain competitive. The biggest problem over the years has been that well-connected corporations have paid little in corporate taxes, forcing the overall rate to be punitive for corporations who cannot exploit political favors.

We can make the system more complicated and less fair (the way we keep going) or else we can re-think the problem and reverse the complexity. The choice should be made by the “human persons” and not the artificial corporate ones.

Notes:

1. See my earlier posts, “The ‘double taxation’ myth” and “A legislator’s guide to tax reform.”
2. See my earlier post, “Taxpayer-financed business failure insurance”